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When complex operations at large banks can sometimes lead to mismanagement and potentially ratcheted-up legal expenses and regulatory fines, not only will shareholders suffer reduced returns, investor confidence can also be negatively affected. Providing one-stop financial services and participating in all aspects of the capital markets, large banks are more inclined to venture their resources into pursuing additional financial activities, making themselves more vulnerable to potential business and legal disputes.

JPMorgan (JPM) and Bank of America (BAC) are the two banks that saw the most expansions coming out of the financial crisis. But expanded business activities require increased internal control and better coordination. Such measures help banks better align their businesses with what financial regulators may deem to be proper or legal. In addition to dealing with heightened regulations, large banks have seen slow margin improvements, stagnant equity returns, and low dividend payouts to shareholders.

Investing in full-service banks can expose investors to a complete line of businesses in banking, capital markets, investment management and other financial advisory services. But meanwhile, any mismanagement of such complex operations can quickly offset the perceived diversification advantage. Legal fees related to litigation and government probes at large banks can easily reach the billions. The rise or fall in such costs is a real factor to a bank's bottom line and shareholder returns.

A recent $7.2 billion charge by JPMorgan to cover the costs of litigation and regulatory probes has led to the bank's first quarterly loss under CEO Jamie Dimon. On the other hand, an over 30% drop in litigation costs at Bank of America helped it report a higher quarterly net income. Whatever the amount of the legal costs as being reported, they represent the money paid out to other parties, instead of potentially being returned to shareholders through dividends or share buybacks.

As large banks have become increasingly more susceptible to all kinds of regulatory inquires, especially in the areas of trading and consumer lending, investing in large banks has also become more vulnerable to related potential settlement losses. This problem comes on top of the already lackluster business performance at large banks, evident by their unimpressive margins and anemic returns on equity. Even Wells Fargo (WFC), the better-performing lender among the largest U.S. banks, has yet to reach an operating margin of 40 percent, a common target for companies considered relatively profitable. Some of its peers have for years tried to lift their operating margins out of the low teens.

Large banks often report net income in the billions, a seemingly impressive result, but they also deploy many times more assets in their operations. Financial data measuring various investment returns actually point to lagging management effectiveness at large banks. In fact, none of the six largest U.S. banks, including the least problematic Wells Fargo, has a return on equity above 15 percent, a goal that Morgan Stanley (MS) has explicitly set out to achieve for some time. ROE for Bank of America is among the worst, barely at above 2 percent.

One can argue on the diversification ground for investing in large banks with multi-line businesses. Large banks often are able to offset the lack of performance in one business, say, trading or lending, with strong showings in another business, maybe investment banking or asset management. But someone else may also argue against such a zero-sum-game strategy. After all, investors expect to see continued increases in stock price and dividend payouts, two things large banks haven't been able to deliver.

While many stocks trade above their equity book value, shares of the largest U.S. banks haven't been able to sell for more than what's actually worth on their books. When it comes to dividend payouts, dividend yields for large banks often range from only a couple of percentage points to otherwise something very minimal. One reason is that payout ratios have been low, even for the best-performing banks, although banks are traditionally notable dividend-paying investments.

To achieve better diversification in the financial sector, investors may consider investing separately in traditional banks and other specialized investment services firms. For example, an investor can select some regional banks, plus some other boutique investment banking firms, to construct a portfolio within the financial sector, an industry too important not to be represented in an investor's total investments.

Something superior with this diversification approach is that investors can easily find some smaller banks and more nimble investment-related companies whose payout ratios often are above industry average. These smaller banks can offer dividend yields that double or triple what large banks can normally deliver. For example, Valley National Bancorp (VLY) and New York Community Bancorp Inc. (NYCB), two New York-area regional banks, both have a dividend yield at about six percent.

With an average market cap at about $2.5 billion, many regional banks like these two also don't present too much volatility risk to investors. More importantly, posing lower systemic financial risks, regional banks and specialized investment firms are also less susceptible to litigation and regulatory probes. Not having to incur additional legal fees will certainly help maintain better margins and a higher ROE.

While large banks often dominate the headlines of what's going on in the financial markets, they don't have to overlook an investor's financial stock portfolios. With all of their legal issues and ineffective performance, not to mention costly employee compensation schemes, investors of large banks may not easily see equally sizable returns. If name recognition doesn't translate into financial results, investors may want to rely a bit more on some less-known banks that can have the most cash distributions.

Source: Banking On Large Banks May Yield Poorer Returns For Investors