Top Ranked Regional Banking ETF In Focus

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December 23, 2013 3:50pm NYSE:KRE NYSE:XLF

in focus spotlightThe finance sector has been the earnings leader this year, adding double-digit returns so far this year. It contributed 19.2% to the Index earnings year to date, the highest among all sectors.

Expense control, sound balance sheets and fewer credit loss provisions enabled the U.S. banks to report earnings growth in the three reported quarters this year. Moreover, loose monetary policy, a reviving housing market, and an upbeat equity market supported the banks on their recovery path.

However, in the third quarter, the rise in earnings notwithstanding, overall growth in the industry was slightly muted due to lesser mortgage activity and lackluster top-line growth.

Total third-quarter earnings in the finance sector increased 9.9% on the back of paltry revenue growth of 0.6%. This compares unfavorably with an earnings climb of 32.5% on 7.9% revenue growth in the preceding quarter.

Moreover, the bigger players were plagued by legal settlement charges. The U.S. Banking industry is still confronting mortgage related lawsuits. Banks of the likes of Citigroup Inc., Bank of America, JPMorgan Chase and Royal Bank of Scotland are coming under increased scrutiny because of these suits.

While the mega banks are hit by huge legal payments, stringent regulatory requirements, falling trading revenue and a relatively larger exposure to government bonds that are generating lesser revenues, the regional banks are clearly stealing the show this time.

Why Regional Banks

Better asset quality and higher loan growth at the regional banks are clearly benefiting these banks more, especially when compared to slower loan growth among the larger players. Hardly any regional bank has been caught on the wrong foot relating to legal suits.

The regional banks mostly serve local retail consumers and the small and medium companies. As such, these banks are less affected by overall banking health and are more tied to the local markets.

Further, many of the regional banks are seeing a pick-up in commercial lending, which will partly offset the effect of a declining mortgage business (Read:Mortgage Finance ETF: A Smart Bet Now?).

Interest rates are expected to rise in the near future since the Fed began to taper its bond buying program in its most recent meeting. In this environment, regional banks will be the beneficiaries as they pay interest at low, short-term rates and lend at higher, long-term rates. Higher interest rates may lead to widening spreads, thereby increasing the profitability of these banks.

Thus a look at the top ranked regional bank ETF could be a good idea to capture the surge, especially when using our Zacks ETF Ranking system.

About the Zacks ETF Rank

The Zacks ETF Rank provides a recommendation for the ETF in the context of our outlook for the underlying industry, sector, style box or asset class.

Our proprietary methodology also takes into account the risk preferences of investors. ETFs are ranked on a scale of 1 (Strong Buy) to 5 (Strong Sell) while they also receive one of three risk ratings, namely, Low, Medium or High.

The aim of our models is to select the best ETFs within each risk category. We assign each ETF one of the five ranks within each risk bucket. Thus, the Zacks ETF Rank reflects the expected return of an ETF relative to other products with a similar level of risk.

For investors seeking to apply this methodology to their portfolio in the regional banking space, we have taken a closer look at the top ranked KRE. This ETF has a Zacks ETF Rank of 1 or ‘Strong Buy’ (see the full list of top ranked ETFs) and is detailed below:

KRE in Focus

Launched in June 2006, SPDR S&P Regional Banking ETF (NYSEARCA:KRE) is one of the most popular regional banking ETFs, having an asset base of $2.7 billion.

The ETF has outperformed the broader U.S. financial services sector ETFFinancial Sector SPDR Fund (NYSEARCA:XLF) by a 12% margin.

The fund tracks the S&P Regional Banks Select Industry Index and uses an equal weight methodology. This methodology eliminates company-specific risk as no single company makes up more than 1.9% of the asset base.

The ETF holds 81 stocks in its portfolio, wherein small caps occupy 56% while mid caps (24%), large caps (10%) and micro caps (10%) capture the rest.

Top holdings of the fund include PrivateBancorp Inc. (1.82%), Texas Capital Bancshares Inc. (1.79%) and PacWest Bancorp (1.79%)  (Read: 3 Insurance ETFs Leading the Financial Sector Higher).

Style-wise, the fund primarily invests in value stocks, which keep investors away from excessive volatility. Moreover, a lack of global exposure makes this ETF less risky compared to other broad banking ETFs.

In fact, the fund has 97% exposure in North American regional banks and a small remaining exposure in Latin American banks.

The fund has delivered an outstanding 43% during the last one year and in the year-to-date time frame.

With improving U.S. economic data and the high probability of rising rates, this ETF is expected to continue with its solid performance going into the New Year.

This article is brought to you courtesy of Eric Dutram.

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