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ETF Specialist

A Low-Cost Way to Bet on Banking

Banks have outperformed broader stocks in 2015, as investors are bullish on higher interest rates and credit quality has stayed strong.

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 SPDR S&P Bank ETF (KBE) provides exposure to the banking sector. This narrowly focused exchange-traded fund tracks a benchmark index that excludes nonbank financial institutions such as REITs, insurance companies, and pure-play investment banks. The fund's focus means that it tends to be slightly more volatile than broader financials-sector funds, like  Financial Select Sector SPDR ETF (XLF). (In comparison, XLF allocates 37% of its assets to banks.) Although most traditional deposit banks hedge a portion of their interest-rate risk, they are especially sensitive to changes in the shape of the yield curve. A flatter yield curve reduces the spread between the rate at which banks can borrow and lend because they fund most long-term loans through short-term deposits. A steepening yield curve tends to have the opposite effect. Consequently, KBE is an appropriate tactical satellite holding for investors who have a high risk tolerance and want to bet on a steepening yield curve and further improvements in the banking sector.

Unlike many other United States equity sectors, the financial-services sector still has not come back to its pre-financial-crisis highs. The reasons for this have been well-documented, including greater regulation, continued ultralow interest rates, asset write-downs, and higher capital requirements. As a result, investors in KBE are faced with considerable risks to the U.S. economy, given that small changes in unemployment and consumer confidence can have a significant impact on loan repayment rates and willingness to borrow. The strength of the housing market can also have a large impact on borrowing and default rates. Adding to these risks, commercial banks and thrifts face an unfavorable regulatory environment, rising capital requirements, and low interest rates, which may limit their profitability and increase competition.

Unlike most of its peers, KBE tracks an equally weighted index, which gives an overweighting to small- and mid-cap stocks relative to a market-cap-weighted benchmark. That means the portfolio is neither concentrated nor dominated by large money-center banks such as  Bank of America (BAC) and  JPMorgan Chase (JPM).

During the past five years, KBE has had a standard deviation of 18.4%. That's much higher than the 11.9% volatility that the S&P 500 has displayed during that period, and it's also slightly above the 15.0%-16.5% volatility levels that broad financials ETFs have displayed during that same period.

Fundamental View
U.S. banks have outperformed the broader U.S. equity market in 2015. Credit quality has been excellent, and investors once again are optimistic about the prospect of rising interest rates and their impact on the banking sector. Banks also have enjoyed relative calm, with no bad news, no major credit issues in energy, and most financial crisis-related settlements concluded.

Ongoing low interest rates have continued to pressure banks' net interest margins. Higher rates may well be a longer-term tailwind for banks, but any immediate benefit from an interest-rate hike would be muted at best, as higher rates will not translate one-for-one into higher earnings for banks. Bank earnings and valuations are driven more by net interest margins, which are more stable over time, than by interest rates. Morningstar's equity analysts don't expect banks' interest-spread revenue to grow anytime soon. Instead, they believe low loan yields will cause interest-spread revenue to stay flat or even decline.

While large banks are far better capitalized than they were before the financial crisis, the March 2015 annual Federal Reserve stress test for 31 large U.S. banks still raised concerns about some large lending institutions. While many big banks, including  Citigroup (C) (which had failed one of the tests in 2014), passed the stress test, Bank of America was ordered to resubmit its capital plan owing to some unspecified deficiencies. As expected, the U.S. trust operations of two major European banks,  Deutsche Bank (DB) and Banco Santander (SAN), failed as well. On top of those concerns, banks continue to face a prominent headwind in the form of elevated compliance, regulatory, and legal costs across the industry, which continue to hit banks' income statements. To counteract lower spread revenue and tighter margins, banks continue to reduce expenses, including cutting staff and branch locations.

U.S. banks have positioned themselves well for the future; stress tests show that banks generally are better capitalized now and can withstand serious economic shock. As a result of the aggressive steps banks have taken to recapitalize after the financial crisis and as a result of conservative underwriting in recent years, banks' capital ratios are improving. A stronger housing market also has lessened the need for reserves, allowing banks to reduce provisions for loan losses. (Banks broadly have had modest success growing their balance sheets.)

Also affecting banks' profitability of late are limited debit-card fees, higher compliance costs, and increased regulation blocking banks from taking deposits and engaging in proprietary trading. Lower unemployment has been a benefit, as unemployment generally keeps borrowing and repayment rates low.

KBE holds no European banks but still faces some risk from Europe. European economic problems could have a contagion effect on large U.S. banks, as European banks are counterparties to large U.S. banks. A continued inability to solve Europe's sovereign debt problems could eventually cascade across the Atlantic and cause U.S. banks to absorb some losses. European banks finally are starting to catch up to U.S. banks on the capital front, somewhat reducing this risk. However, their capital ratios still meaningfully lag those of U.S. banks.

Portfolio Construction
The fund tracks the modified equally weighted S&P Banks Select Industry Index. This index contains 61 companies in the GICS banking industry from the S&P Total Market Index. In order to qualify for inclusion in the S&P Bank Select Industry Index, each stock must meet liquidity requirements and represent a bank based in the U.S. While S&P applies equal weighting, it makes adjustments where necessary to ensure adequate liquidity in each of the constituents' shares. This equal-weighting approach can create higher turnover than a comparable fund tracking a market-cap-weighted index. In fact, the fund's turnover was 29% for the year ended December 2014. S&P rebalances the index quarterly. KBE's equally weighted portfolio gives it a mid-cap tilt; small- and mid-cap companies represent 85% of the portfolio. Consequently, its holdings' average market cap is only $6.7 billion. Unlike broad financials-sector funds, KBE excludes nonbank financial institutions such as REITs and insurance companies.

KBE charges a 0.35% expense ratio, which is reasonable for its niche exposure. However, there are cheaper broad financials-sector ETFs available. KBE's average daily trading volume of 1.6 million shares helps keep its bid-ask spread tight and the market impact of trading low. State Street engages in share lending, the practice of lending out the fund's underlying shares in exchange for a fee. It passes 85% of the gross proceeds to investors, which partially offsets the fund's expenses. KBE's estimated holding cost is 0.26%. Estimated holding costs are primarily composed of the expense ratio but also include transaction costs, sampling error, and share-lending revenue.

 SPDR S&P Regional Banking ETF (KRE) is a suitable alternative for those desiring more-diversified exposure to traditional deposit and loan banks. KRE does not hold large money-center banks. The regional banks and thrifts that KRE owns offer greater diversification benefits than national banks because they are more sensitive to local market conditions, which are less correlated. Similar to KBE, KRE equally weights its holdings. About 56% of the two ETFs' portfolios overlap. KRE charges a 0.35% fee.

The more-concentrated PowerShares KBW Bank ETF (KBWB) (0.35% expense ratio) tracks a cap-weighted index of 24 national money-center banks and regional banks or thrifts. KBWB has fewer assets than KBE and far less liquidity, so investors should watch bid-ask spreads closely.

Those seeking broader exposure to the U.S. financial-services sector should consider the inexpensive  Financial Select Sector SPDR ETF (XLF) (0.14% expense ratio), which is the most liquid financials-sector ETF available. It owns every financials firm in the S&P 500, so it has a more concentrated portfolio with a large-cap tilt. Large diversified banks have greater weightings in XLF than in KBE. Over the past five years, KBE and XLF were 92% correlated, with XLF exhibiting slightly less volatility.

 Vanguard Financials ETF (VFH) dips further down the market-cap ladder to offer broader exposure to U.S. financials firms. It owns all 559 financial-services firms in the MSCI U.S. Investable Market 2500 Index, including small and mid-caps. VFH charges 0.12%.

Finally, the large and liquid  iShares U.S. Financials (IYF) holds a broad portfolio of 288 financial-services firms but charges an unappealing 0.43% fee.

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Robert Goldsborough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.