IAT: Playing Survivor with Regional Banks

Bank shares soared Monday as government officials discussed the details of a bank rescue program with executives from the largest U.S. institutions. Analysts also continued to speculate about the impact that the stimulus plan would have on smaller, regional banks and to question the involvement that these banks would have in the bailout process. Many regional banks have seen share prices improve in recent months, as policy and scrutiny separate good assets from bad in the public eye. As the panic subsides, regional banks are gaining a foothold, and the iShares Dow Jones U.S. Regional Banks Index Fund (IAT) moved from the No. 39 position to the No. 5 position in our Sector Momentum Table from September 2 to October 7.

IAT tracks the price and yield, before fees and expenses, of the Dow Jones U.S. Select Regional Banks Index. This index is a subset of the Dow Jones U.S. Banks Index, comprising small and midsize banks. Criteria for index inclusion weigh heavily upon each bank’s relative three-year average total assets as a percentage of the three-year average total assets held by all banks in the Dow Jones U.S. Banks Index.

Barclays Global Fund Advisors (BGFA), the index provider for IAT, uses a representative indexing strategy to passively manage the fund. This strategy involves investment in a sample of the index’s securities that collectively have an investment profile similar to the underlying index. Together, the index components should have fundamental characteristics and liquidity measures similar to those of the underlying index. This methodology attempts to capture the returns of the general index, not the movement of any single component.

While its indexing strategy mitigates some component risk, IAT still has a fairly large exposure to its top holding, US Bancorp (USB). More than 19% of IAT’s portfolio is weighted in USB, so fund investors would be wise to watch for news from this holding. USB has made an effort in recent weeks to stay in step with Fed initiatives, cutting its prime rate from 5.0% to 4.5% on October 9, after the Fed announced a similar measure. Offering a yield of 4.6%, shares of USB have been a popular alternative for financial sector investors unwilling to test the waters of riskier banks.

Some of the more conservative banks included in IAT’s portfolio—which did not take on as much risk in the subprime market—may not experience the upswing felt by more aggressive banks when the market turns. On Monday, October 13, many of the larger banks that had been devastated by the financial crisis rallied significantly as government officials made allocation decisions for the bailout package. Smaller banks—like the ones found in IAT’s portfolio—did not rally as much as those banks expected to participate in the bailout package. This relationship appears to be a classic illustration of the risk/reward principle.

IAT made several proactive portfolio changes in September that aided the fund’s returns. Historically, adjustments to the fund have been relatively small and spread out over time. As banks faltered and dove over the past several months, however, changes to IAT’s portfolio have become more aggressive. Component changes were made on September 22, 24, and 30, and eight components were removed from the index in that period. The majority of the changes—six in total—took place on September 22. On September 24, Union Bank (UB) was removed from the index in the wake of a buyout announcement from a Japanese firm. On September 30, Washington Mutual (WM) was removed from the index—a move that appears to be good timing in light of a recent precipitous drop in share value.

After a historic rally October 10, Jack Ablin, chief investment officer with Harris Private Bank, noted, “Financials overall are trailing the pack, but the companies leading the charge in the sector Monday were the ones pretty much on the ropes.” Ablin suggested that “the market must have felt that some of the others were survivors and investors are pulling money out of those banks. It’s a reverse flight to quality, a flight to speculation.” While IAT may not benefit from this flight to speculation, it is a “survivor” fund in a volatile marketplace. For those investors looking to capture a more conservative stake in an oversold sector, IAT could provide more stable returns.