The focus on TARP funds and the governments around the globe has been to save the “too big” to fail financial institutions and not focus on smaller banks, often the more sound banks, and the exchange traded funds (ETFs) that track them.

Not All Are Bad. There are some financial institutions out there that have relatively clean balance sheets, didn’t overextend themselves by issuing bad loans and aren’t involved in credit card nightmares. The beauty of these banks is that they can borrow for free, don’t have to offer much, if any, of a return on customer deposits, and can lend with a rate of 6% to 11%. Sounds like a winner doesn’t it? The problem arises on a bank’s willingness to take risk via sound lending standards and that qualified borrowers want to borrow, states Gary Gordon at ETF Expert.

Tricky Playing Financials. For ETF investors, playing the financials is a bit challenging because most of the indexes are market-cap weighted. If investing in the Financial Select SPDR (XLF), which is down 25% over the last month, one is mostly investing in the largest financial institutions.

This predicament may be alleviated through the use of Rydex Equal Weight Financials (RYF), which is a fund that tracks small, medium and large financial companies in equal proportion. It’s not down as sharply as some of the other financial ETFs – 12.3% over the last month.

Less Exposure. Regional banks also had less exposure to toxic assets that brought the industry to its knees in 2008. the KBW Regional Bank (KRE) was down 20.9% in 2008, compared with the 56.8% decline seen in the Financial Select Sector SPDR (XLF) in the same time frame.

It still seems like an uphill battle for the financial sector and the sector is far from flashing a green light. However, if one still desires to play financials, a more diversified index might be an option.

Read the disclosure, as Tom Lydon is a board member of Rydex Funds.

Tags: Financial, Green ETFs, KRE, RYF, Sector ETFs, XLF