Bank On This ETF As A Fed Play

As the Federal Reserve ebbs closer to its first interest rate hike in nine years, investors' enthusiasm for bank stocks and exchange-traded funds is growing. That much is reflected by the Select Sector Financial Slct Str SPDR Fd (NYSE:XLF).

The Largest Financial Services ETF

XLF, the largest financial services ETF, has surged 9.2 percent this quarter on its way to adding more than $1.6 billion in new assets. However, XLF, one of the fourth quarter's top asset-gathering ETFs, and comparable financial services ETFs have exposure to real estate stocks, which are negatively correlated to rising interest rates. The good news is investors have plenty of ETF options when it comes to pure banking plays.

Pure Banking Plays

Although financial services stocks, on a historical basis, have questionable reactions to increases in borrowing costs, conventional wisdom holds that the sector is positively correlated to higher interest rates.

One of the favorites is the $2.89 billion SPDR KBW Bank (ETF) (NYSE:KBE). Though it is not a dedicated regional bank ETF, KBE is heavily allocated to regional banks the banking stocks believed to be most positively correlated to higher interest rates.

Higher interest rates are seen as boons for regional banks' net interest margins, a key measure of profitability for these banks.

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, said Morningstar in a recent note.

KBE's Holdings

KBE equally weights its 63 holdings with none commanding weights in excess of 1.9 percent. That means although the ETF is home to banking giants such as Bank of America Corp (NYSE:BAC) and Dow component JPMorgan Chase & Co. (NYSE:JPM), those stocks are no more important drivers of KBE's returns than are names such as Bank Of The Ozarks Inc (NASDAQ:OZRK) and Cullen/Frost Bankers, Inc. (NYSE:CFR).

KBE's Performance And Subsequent Volatility

That mix has helped KBE to a fourth-quarter gain of 10 percent, or 80 basis points better than XLF. Since mid-September, KBE has added nearly $500 million in new assets. However, KBE's tilt away from the biggest bank stocks also ups the ETF's volatility.

During the past five years, KBE has had a standard deviation of 18.4 percent. That's much higher than the 11.9 percent volatility that the S&P 500 has displayed during that period, and it's also slightly above the 15.0 percent16.5 percent volatility levels that broad financials ETFs have displayed during that same period, added Morningstar.