With the plethora of exchange traded fund options to choose from, investors should carefully look under the hood of a prospective ETF investment, even if two sound similar and track comparable strategies.
Since the November elections, bank stocks have outperformed due to a combination of favorable factors, like renewed enthusiasm for higher interest rates, optimism over corporate tax reform, reduced regulatory burdens and improved earnings growth.
“Despite the large rally, there are differences in performance among the banks, based on the size of the banking institution and the type of services offered,” according to Keefe, Bryette & Woods. “Investors using associated exchange-trade fund (ETF) products to either make positions or hedge equity exposures benefit from using precise bank indices. These indices also provide the most relevant bank benchmarks for comparative purposes.”
When looking for exposure to bank stocks, ETF investors have a number of are a number options to choose from, including the PowerShares KBW Bank Portfolio (NYSEArca: KBWB), SPDR S&P Bank ETF (NYSEArca: KBE), PowerShares KBW Regional Bank Portfolio (NYSEArca: KBWR) and SPDR S&P Regional Banking ETF (NYSEArca: KRE). These options appear to be two decent plays in the current environment where President Donald Trump has laid out plans to rollback the Dodd-Frank financial-overhaul law, potentially freeing up the firms to achieve more aggressive growth targets.
However, investors should not confuse the bank ETFs with regional bank ETFs as the two categories provide very different exposures. Specifically, universal and large regional banks are most impacted by industry regulation and Federal Reserve policy, and they are exposed to higher associated regulatory costs and lower merger and acquisition opportunities. On the other hand, regional banks provide investors with more geographical exposure and M&A opportunities.
Regional banks also trade at higher valuation multiples. At the end of January, regional banks showed a premium of 39% to universals and 17% to large regionals. KBWB is trading at a 14.2 P/E while KBWR is trading at a 18.1 P/E.
KBWB tracks the KBW Nasdaq Bank Index while KBWR follows the KBW Nasdaq Regional Banking Index. According to Keefe, Bryette & Woods, the two underlying Bank and Regional Banking indices replicate investable large-cap and regional-bank segments, respectively, with no overlap between the two indices.
KBE follows the S&P Bank Select Industry Index while KRE reflects the performance of the S&P Regional Banks Select Industry Index. Keefe, Bryette & Woods analysts pointed out that about 89% of KRE’s weighting comes from KBE’s underlying index. Additionally, the two indices trade at similar fundamentals. KBE has a 15.7 P/E and KRE shows a 16.6 P/E.
“This significant membership overlap erodes differentiated bank performance,” Keefe, Bryette & Woods analysts warned, adding that KBE and KRE’s underlying indices are nearly identical with a 0.98 correlation, compared to KBWB and KBWR’s underling indices’ correlation of 0.90.
For ETF investors, it is important to take a close look at the underlying holdings and indices to get a better sense of what you are investing in.
KBWR and KBWB’s underlying indices “are more narrowly defined than the S&P bank indices, with tighter constituent market-cap ranges and smaller constituent groups, representative of their respective capitalization focus,” Keefe, Bryette & Woods analysts added.
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.