In Banking, Regional Is the Way to Go

01/21/2010 12:00 pm EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, Morningstar’s director of ETF analysis, and analyst John Gabriel say regional banks have been laggards among financial stocks, but they may catch up soon.

SPDR KBW Regional Banking (NYSEArca: KRE) offers investors a direct play on this subsector of the financial industry. We like the diversification benefits this ETF offers and think that investors looking to bet on a recovery in this beaten-down subsector should consider KRE as a tactical satellite holding.

This fund tracks the KBW Regional Banking Index, which encompasses 50 holdings that it equal weights, rebalancing on a quarterly basis. This portfolio is arguably the purest play on regional banks among the current crop of regional-banking ETFs. [It] invests roughly three-fourths of assets in small-cap firms, with the balance in mid caps. This is in sharp contrast to its cap-weighted peers

The game has changed in the financial sector. The banking business model is quickly evolving to resemble that of a regulated utility—that is, stringent oversight and lackluster top-line growth.

[Many] regional banks, once often characterized as conservative institutions that conducted business largely inside their geographic footprints, went astray near the end of the housing boom by increasing their exposure to subprime and Alt-A mortgages to keep pace with larger investment and commercial banks.

[But] not all regional banks took on the same levels of risk, and there will no doubt be winners and losers after the dust from the credit crisis settles. The beauty of this ETF is that its equal-weighting approach across its 50 holdings should mitigate the impact of any blow-ups.

KRE is composed of smaller regional banks and community thrifts like Umpqua Holdings (Nasdaq: UMPQ), Sterling Bancshares (Nasdaq: SBIB), and PrivateBancorp (Nasdaq: PVTB).

At the end of the day, the banks included in KRE’s portfolio exhibit more of the characteristics we’d expect from traditional regional banks—conservative loan books, considerably less leverage, and business models centered around gathering local deposits.

While regional banks held up relatively well in 2008—KRE’s 18.5% drop in 2008 paled in comparison to the 55% plunge turned in by the broader-based Financial Select Sector SPDR (NYSEArca: XLF) over the same period—2009 was rough on the industry.

In fact, KRE shed more than 22% of its market capitalization in 2009. It may also be that investors have realized that the regional banks are suffering from many of the same issues that have roiled their larger counterparts—primarily exposure to toxic and illiquid assets.

The unfortunate reality for the regional banks, however, is that they don’t benefit from falling under the “too big to fail” umbrella. As such, fundamentals (and not potential systemic implications) should dictate the performance of the group going forward.

This fund’s 0.35% expense ratio makes it the cheapest of the three regional bank ETFs that are currently available. However, it’s a tad pricier than the cheapest broad financials ETFs.

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