Three Financial ETFs That Avoid Big Bank Stocks (XLF, JPM, BDCS, QABA, PSCF, RKH, IYG)

Eric Dutram: The past month has been pretty unkind to the big banks for a variety of reasons. Speculation continues to build regarding a broad European default centered around Greece which could trigger a number of issues for many banking stocks in the near term.

Beyond this, the focus has been on JP Morgan (NYSE:JPM), often considered the best run big bank on Wall Street after the crisis of 2008. However, the firm has been under fire as of late thanks to a massive $2 billion trading loss at the company’s London desk (see more on ETFs at the Zacks ETF Center).

Although the loss was relatively small given that the trade was over$100 billion, the move is causing many to question the ability of large banks to police their own offices and properly manage their own trading desks without more government supervision. In fact, many regulators are already reviewing the situation while Fitch Ratings has lowered the firm’s credit rating by one notch to ‘A+’.

The big dollar amount of the loss has also renewed political calls for more banking oversight, a trend that has only been exacerbated by the upcoming elections. Now, thanks to the perception that if this can happen to JPM it can happen to anyone, along with the political softball that this situation has provided many in Congress, many are forecasting that more regulation could be on the way for the sector (also see The Complete Guide to Preferred Stock ETF Investing).

Overall, the focus has been on the return of the Glass-Stegall Act,tougher draft rules on the Dodd-Frank bill or the so-called ‘Volcker Rule’. With these potentially stiffer rules, the profitability of banks could suffer across the board while their future activities could be limited as well.

In addition to this, there are also worries that JPM could see even greater losses stemming from the unwinding of its trade which could push the $2 billion loss far higher. With JP Morgan facing this issue there are also concerns that similar problems could be underneath the surface of many other large banks causing many investors to head for the exits in the space.

In fact, over the past month, Financial ETF (NYSEARCA:XLF) has fallen by about 4.7%, while more focused products such as (NYSEARCA:IYG) and (NYSEARCA:RKH) have fallen by even greater amounts; 6.7% and 9.3%, respectively, in the time period (read Three Financial ETFs Outperforming XLF).

Fortunately, the weakness hasn’t permeated all segments of the financial sector and there are some good choices left in the space. In particular, a focus on smaller banks or more obscure segments of the financial ETF world could be the best way to go in this heightened risk environment.

Furthermore, looking at more U.S. focused securities could help to insulate investors from the worst of the European debacle, a situation which could impact many large banks even if further regulations are not realized. For investors looking to apply this approach, any of the following three financial ETFs could be great picks that stay in the sector but avoid big bank exposure:

PowerShares S&P SmallCap Financials Portfolio (NASDAQ:PSCF)

If investors are looking to avoid both big banks and other large financial institutions, the broadly focused PSCF could be a good pick. The product also has ample interest from investors although the volume is a little light at about 10,000 shares a day.

Still, the product does represent a decent value as the expense ratio is just 29 basis points a year while the yield is approaching 2%. In total, the ETF holds just over 100 securities, all of which are based in the U.S.

In terms of sectors, REITs take up 40% of the fund, followed by a 35% allocation to banks, and 14% to insurance. The ETF also does a great job in eliminating big financial institution exposure as just 3% of the fund is classified as mid cap or greater while it also has a value tilt; nearly two-thirds of the fund can be described as value securities.

UBS E-TRACS Wells Fargo Business Development Company ETN (NYSEARCA:BDCS)

For a high yield approach in the segment, investors have this ETN as a decent choice. The product is still somewhat unpopular from a market cap and volume perspective but it does pay out a robust yield of 7.6%, more than enough to cover the hefty 85 basis point fee.

Securities that are represented in this ETN tend to lend out capital to small and midsized companies at relatively high rates. Often times, BDCs make loans and take equity stakes, meaning that if things go right investors can benefit from both cash flows and capital appreciation (see Top Three High Yield Financial ETFs).

However, it should be noted that the space is often quite volatile and large losses can be had in a short period of time.  Still, it represents a great way to avoid big banking institutions while still maintaining exposure to the traditional lending activities of the space.

Currently, the product has a heavy value tilt as only 1% of the product is in blend securities with the vast majority in value (77%) and pure value (22%). From a market cap perspective, micro cap securities dominate with nearly 70% of assets, although mid caps (20%), and small caps (11%) do account for decent chunks as well, giving the fund a decided focus away from the biggest lenders in the financial world.

First Trust NASDAQ ABA Community Bank Index (NASDAQ:QABA)

For a focus on small cap banks, QABA presents an interesting choice. However, the fund is still somewhat unpopular with investors as it has just $11 million in AUM and trades about 7,000 shares a day.

Nevertheless, the product, which charges investors 60 basis points a year, holds over 100 positions in small banks from across the country. Furthermore, the product promises to exclude all of the 50 largest banks or thrifts based on assets size while also excluding firms that have an international or credit card specialization (readBeware These Three Volatile Financial ETFs).

This process produces an ETF that has just 19% of its assets in securities defined as mid cap or greater and instead puts 46% in small caps, and 35% in micro caps. From a style perspective, value securities dominate; just 14% of the portfolio can be defined as either blend or growth stocks.

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Written By Eric Dutram From Zacks Investment Research

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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