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By Alex Bryan

While U.S. banks have taken a beating over the past few years, they are now better capitalized, as a result of adopting more conservative lending standards. The housing market is also starting to show signs of life, which could strengthen banks’ profitability. Plenty of risks remain. Banks face an unfavorable interest-rate and regulatory environment that may preclude them from returning to their precrash levels of profitability. Yet, regional banks may offer investors the best way to take advantage of attractive valuations in the financial services industry.

Regional banks offer greater diversification benefits than do national banks because their performance is more closely attuned to the health of their local markets. SPDR S&P Regional Banking ETF (NYSEARCA:KRE) offers an equally weighted portfolio of 76 regional banks that provides pure exposure to this subsector of the financial services industry. KRE is an appropriate tactical satellite holding for investors who have a high tolerance for risk and want to bet on a strong U.S. recovery.

Retail customers and local small and midsized companies tend to represent a large portion of regional banks’ customer base. While these customers tend to be concentrated in each bank’s geographic market, this works to KRE’s advantage because there is little overlap between its holdings’ market exposures. Consequently, over the past five years, KRE was slightly less volatile than SPDR S&P Bank ETF (NYSEARCA:KBE), which includes larger commercial banks. However, many regional banks lack sufficient scale to match larger banks’ cost efficiency, which may make them less competitive in a low-interest-rate environment. Additionally, they don’t fall under the “too big to fail” umbrella, so they may not receive government support if they get into trouble.

Although the worst of the financial crisis has likely passed, KRE continues to expose investors to considerable risks. Small changes in unemployment and consumer confidence can have a significant impact on loan repayment rates and willingness to borrow. The strength of local real estate markets can also have a large impact on borrowing and default rates. Changes in the shape of the yield curve compound these risks. A flatter yield curve reduces the spread between the rate at which banks can borrow and lend because they fund most long-term loans through short-term deposits. While a steepening yield curve tends to have the opposite effect.

Fundamental View
Many regional banks, once often characterized as conservative institutions, veered off course near the end of the housing boom by increasing their exposure to subprime and Alt-A mortgages in an effort to keep pace with their larger rivals. However, the quality of these banks’ loan portfolios has improved over the past few years, as a result of more conservative underwriting and a strengthening economy. With lower default rates, regional banks continue to reduce their loan loss provisions, which has boosted their earnings. Capital ratios are also improving. Consequently, KRE’s holdings are better positioned to weather adverse shocks than they were a few years ago.

Although U.S. banks will likely continue their slow recovery over the next few years, profit margins from the precrisis period are not a good indicator of banks’ future profitability, because regulatory changes have permanently changed the banking business. Under Basel III banks will be required to hold a greater portion of their assets in reserve to reduce systemic risk. This will reduces the amount banks can lend, which should reduce their profitability. The version of the Volcker Rule adopted in Dodd-Frank further constrains profitability by prohibiting banks that take deposits from engaging in proprietary trading, with limited exceptions. Dodd-Frank also caps fees banks can charge on debit cards and will almost certainly increase compliance costs. While these regulations limit the range of activities financial services firms can undertake, they should also reduce risk.

Low interest rates and high unemployment will also likely continue to weigh on the sector’s profitability. The Fed’s commitment to keep short-term interest rates near zero, as long as unemployment is above 6.5% and inflation is below 2.5%, may continue to limit banks’ interest margins. High unemployment tends to depress borrowing and repayment rates, which creates a hurdle for revenue growth and can lead to large loan write-downs. However, if unemployment continues its gradual decline, banks will have room to improve their earnings.

Renewed strength in the housing market should also help. New household formation is rising, the inventory of unsold homes is being whittled down, and new housing starts and sales are up year-over-year. Higher home prices could allow more homeowners to refinance their mortgages at lower rates, giving them more money to spend elsewhere. If the housing market continues to strengthen, it would likely reduce default rates, and increase the value of banks’ collateral and mortgage backed securities. The Fed’s latest round of quantitative easing, its commitment to buy mortgage-backed securities, should keep mortgage rates low and spur demand. The Mortgage Bankers Association estimates that homeowners refinanced $342 billion in mortgage debt in the third quarter of 2012, up 32% from the previous year.

As of this writing, the fund is trading at a discount (13) to its average price/earnings ratio since its inception in 2006 (15.4), and close to book value.

Portfolio Construction
KRE tracks the modified equally weighted S&P Regional Banking Select Industry Index. This index includes 76 companies in the GICS Regional Banks subindustry from the S&P Total Market Index. In order to qualify for inclusion in the S&P Bank Select Industry Index, each stock must meet liquidity requirements and represent a bank based in the U.S. While S&P applies equal weighting, it makes adjustments where necessary to ensure adequate liquidity in each of the constituent firms’ shares. This equal weighting approach can create higher turnover than a comparable fund tracking a market-cap-weighted index. In fact, the fund’s turnover was as high as 44% for the year that ended in June 2012. S&P rebalances the index quarterly.

KRE’s equally weighted portfolio overweights small-cap firms relative to its market-cap-weighted peers. It invests nearly 58% of assets in small-cap firms, and 29% in mid-caps. As a result, its average market cap is only $2.4 billion.

Fees
The fund’s 0.35% expense ratio makes it the cheapest regional bank ETF available. However, it is more expensive than alternative broad financial sector funds. KBE’s average daily trading volume of more than 2 million shares helps keep its bid-ask spread reasonably tight and the market impact of trading low. State Street engages in share lending, the practice of lending out the fund’s underlying shares in exchange for a fee. It passes 85% of the gross proceeds to investors, which partially offsets the fund’s expenses.

Alternatives
IShares Dow Jones US Regional Banks (NYSEARCA:IAT) (0.47% expense ratio) offers similar niche exposure. However, it includes a handful of super-regional banks, such as U.S. Bancorp (NYSE:USB) and PNC Financial Services Group (NYSE:PNC). In contrast to KRE, IAT weights its holdings by market cap, which makes its portfolio top heavy and gives it a higher average market cap. IAT’s top 10 holdings soak up 63% of its assets. PowerShares Dynamic Banking (NYSEARCA:PJB) offers a similar small-cap tilt to KRE. However, instead of tracking a traditional index, PJB follows a quantitative screening model that selects stocks based on valuation and risk factors. This fundamentals-driven approach can create style drift and make PJB a less reliable way to gain exposure to regional banks. Yet, over the past five years, PJB and KRE were 0.97 correlated. PJB charges an expense ratio of 0.60%.

SPDR S&P Bank ETF (KBE) also offers pure exposure to traditional commercial banks and thrifts. But it includes large national money center banks, in addition to many of the larger regional banks KRE owns. Slightly over half of these two funds’ portfolios overlap. KBE charges an annual fee of 0.35%.

Investors looking for broader exposure to the U.S. financial services sector should consider Financial Select Sector SPDR (NYSEARCA:XLF). XLF is the cheapest (0.18% expense ratio) and most liquid financial sector ETF available. It owns every financial services firm in the S&P 500 Index, which gives it a more concentrated portfolio with a large-cap tilt. Vanguard Financials ETF (NYSEARCA:VFH) climbs further down the market-cap ladder. It owns all 500 financial services firms in the MSCI U.S. Investable Market 2500 Index, making it the broadest U.S. financial sector ETF available. VFH charges 0.23%.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Regional Banks: Small Enough To Succeed