Banks: Systematic and Non-Systematic Risk

Includes: KBE, XLF
by: Richard Shaw

Large banks are way down in the past 12 months, and as a consequence their trailing yields are well above normal. That potentially creates substantial long-term equity income opportunity, but the big question is whether the dividends that make those yields will hold or be cut.

If you subscribe to the “buy it when it’s cheap” philosophy, then you really need to evaluate any sector when it sinks the way large banks have done.

If you conclude that taking a position (partial or full) in large banks is the right thing to do, we believe that you should buy the sector, not individual banks (unless you have high research-based conviction about the individual company).

If you buy the sector, you are exposed to systematic risk for banks (general market risk and industry specific risk, such as more mortgage market trouble). You would probably hold some stinkers in the group, but you would also hold the winners. That means that a few banks with negative surprises will not destroy the income advantage of the sector.

If you buy individual banks, you take on systematic market and systematic sector risk, but also non-systematic (individual company) risk. With individual banks, you have greater risk of permanent capital loss (some banks could fail), greater price volatility risk, and greater risk of yield reduction through dividend cuts.

Two good ETFs to participate in large banks are Financial Select Sector SPDR (NYSEARCA:XLF) (S&P 500 financials sector, which also includes insurance and investment banking) and streetTRACKS KBW Bank ETF (NYSEARCA:KBE) (KBW large bank index).

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