As the financial sector and its exchange traded funds (ETFs) have been on a rollercoaster ride over the past year, not all of the sector’s ETFs are created equal. 

While the bulge-bracket banks have boomed, local and regional banks have been depressed by a spate of bankruptcies. Small U.S. financial institutions have seen 106 bank closures and some analysts think there are more to come.

Daniel Harrison of Index Universe states that the polarization between the performance of large and small financial institutions has been felt acutely in the ETF arena, where many have used ETFs to hedge against long stock positions.

Regional banks performed so well at the height of the financial crisis, thanks to their avoidance of exotic and complex financial instruments (such as credit default swaps) that took down their larger brethren. But that doesn’t mean that smaller banks were invulnerable to trouble themselves. Now that big banks are doing so well, why are the smaller banks suddenly faltering?

  • Exposure to commercial real estate. Commercial defaults have risen to 2.25%, up from 1.61% in the first quarter. It’s expected to rise to 4.1% before year’s end.
  • Home foreclosures. Despite government efforts to stem the tide, the fact is that homeowners are still foreclosing, and small banks make many of these loans. The rate of foreclosures is up to 13%, says Kent Bernhard Jr. at Portfolio Magazine.
  • Unemployment. As unemployment continues to rise, it will put a strain on personal loans, mortgages, commercial loans and credit.
  • Bad loans in general are running three to four times higher than they were two years ago.
  • It’s tough to raise money when you’re small. If small and regional banks could raise capital, it could mitigate the problems.

When comparing the big banks with regionals, there is a fairly large discrepancy when it comes to performance.  The SPDR Financial Select Sector (XLF), which tracks the large institutions, is up 14% year-to-date, compared to the SPDR KBW Regional Banking (KRE), which is down 30.5% year-to-date.

This doesn’t mean that opportunities don’t exist for investors who are considering regional banks.  The Regional Bank HOLDRs (RKH) is up 0.7%.  What differentiates this ETF from KRE is its level of diversification.  Nearly 93% of RKH’s assets are held in its top 10 holdings as compared to 27% in KRE.  It is vital for investors to educate themselves and know exactly what an ETF holds in order to gain the exposure they’re seeking to regional banks.

For more stories on financials, visit our financial category.

Kevin Grewal contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.