Buying banks via an ETF is more difficult than you might think. Many ETFs simply bundle bank stocks in the larger "financials" category, which includes insurance companies, real estate operators, and private equity stocks.
And many ETFs put so much of their assets under management into the big four banks -- Bank of America, Wells Fargo, Citigroup, and JPMorgan -- that they only give you modest or no real exposure to much smaller regional and community banks that, albeit small, are still a very important part of the banking industry.
Below, we'll show you the best picks in bank ETFs, from equal-weighted ETFs for small banks, to a market-cap-weighted bank ETF for large banks, and lay out the case for each of them. But let's start with the basics...
Why bank stocks?
When most people think of bank stocks, they think of the crises -- the 2008 financial crisis, the 1997 Asian financial crisis, the savings and loan crisis of the 1980s and early 1990s, or the Great Depression in the 1930s. But the truth is that through the turbulence, well-run banks have been extraordinary investments.
Don't take my word for it, though. Warren Buffett, widely regarded as the best investor to ever live, owes much of his stock-picking record to bank stocks. Early investments in American Express, Wells Fargo, M&T Bank, and others, have bolstered his long-run returns. Even today, his company, Berkshire Hathaway, holds more than $67 billion of its $194 billion stock portfolio in bank stocks, a testament to the industry's investment merits.
Even past banking bears have turned into bulls. Steve Eisman, for instance, who rose to fame thanks to The Big Short, has said that he believes banks are poised for years of good performance, thanks to their "clean" balance sheets, and the fact that banks are now using much less leverage than they did prior to the 2008 financial crisis.
Banks may be complicated, but the core business is rather simple. There's an old joke that bankers follow the "3-6-3 rule": They borrow money from depositors at 3%, lend the money back out at 6%, and hit the golf course by 3 p.m. It's oversimplified, but it accurately describes what banks do: They borrow at one rate of interest and lend it out at a higher rate of interest, collecting a spread between what they pay on deposits and what they earn on loans.
The different types of banks (and bank ETFs)
Banks are unique because what they do is often a function of how big they are. While there isn't a fundamental difference between a retailer with 10 stores and one with 1,000 stores, there are very big differences between a bank with $1 trillion of deposits and another with $100 million of deposits.
Bank stocks are generally broken down by size into three big groups: money center banks, regional banks, and community banks. Each has its own pros and cons, and there are ETFs that track each category.
1. Money center banks
Money center banks are the Goliaths of the industry, providing banking services to the largest companies (think Coca-Cola), governments, and even smaller banks, sometimes across international borders.
These banks can be thought of as "wholesale" banks because they deal primarily with really big loans, really large depositors, and really big businesses (ones that trade on Wall Street, for example). All of the big four banks -- Bank of America, Wells Fargo, Citigroup, and JPMorgan -- are money center institutions.
To put their size in perspective, consider that a single loan issued by a money center bank could easily exceed all the loans issued by a smaller regional or community bank. When a convenience store needs a loan, a small bank will do. But if Walmart needs a $1 billion loan, the money center banks are the only ones big enough to fund it.
Money center banks are often universal banks that are involved in just about everything banking related, from issuing personal credit cards all the way up to capital markets activities like helping companies sell stock to the public in initial public offerings (IPOs). So, not only are money center banks geographically diverse, but their sources of income are diverse, too.
Why invest in money center banks?
The size and scope of money center banks set them apart from their smaller counterparts. Here's what makes money center banks different:
- Cost advantages: American megabanks have a leg up on their smaller rivals just by virtue of their size. Whereas the average community bank has less than $5 million in assets per employee, larger banks can have $10 million or even $20 million in assets per employee (the average across all banks of all sizes is $8.4 million per employee).
- Fee machines: Large money center banks are just as much fee generators as they are lenders. Large banks generate fee income from advising clients on how to invest for retirement, helping companies go public, facilitating payments by credit and debit cards, and by charging fees $5 or $10 at a time on millions of clients' checking and savings accounts. Fee income is extremely valuable for a bank because it is earned by providing a service rather than taking risk. A bank might haul in $20 million in fees advising on an IPO, pay its bankers $10 million for the work, and keep $10 million for shareholders. To earn a similar amount from lending, a bank would have to risk as much as $1 billion in making loans. Banks normally have to risk a lot to make very little, so any income they can earn without putting money at risk is a beautiful thing.
- Diversification: Owning large bank stocks is like owning a royalty on the U.S. economy, because they have loan exposures across the country, not just in one city or state. A prolonged downturn in energy prices could very well ruin a Texas-based community bank, but national banks with diversified loan portfolios would be able to shrug off the resulting loan losses.
Because money center banks are large, they aren't necessarily fast-growing institutions. But as a result of relatively slow growth, they can shower their shareholders with financial rewards. Large banks typically pay out a majority of their earnings in dividends and share repurchases, in contrast to smaller, faster-growing institutions, which have to retain their earnings to fund their growth.
The easiest way to buy into large bank stocks is to buy ETFs, which are publicly traded funds that hold other stocks. Think of an ETF as a container that holds a large number of stocks -- many bank ETFs hold between 20 and 200 bank stocks.
The Invesco KBW Bank ETF (NYSEMKT: KBWB) provides easy exposure to the largest banks on U.S. markets, as it includes exactly 24 of the largest publicly traded banks, weighted by their market cap adjusted for their share price. The ETF is designed to track the KBW Nasdaq Bank Index, which is to the banking industry what the Dow is to the largest U.S. stocks. Just as the Dow Jones Industrial Average includes only 30 of the largest companies on the market, this index is designed to track just 24 of the largest banks on the market.
And while 24 bank stocks may seem like too few for real diversification, consider that the banks that make up the lion's share of the ETF make up a similarly large portion of the U.S. banking industry. Citigroup, JPMorgan Chase, Bank of America, and Wells Fargo each make roughly 8% of the ETF, or 33% of the ETF's assets. Conveniently, that's roughly equal to their combined market share of U.S. banking deposits -- roughly $1 out of every $3 deposited in a bank in the United States is held by one of the big four banking institutions.
The only downside to the Invesco KBW Bank ETF is that it is relatively costly given that it doesn't hold that many stocks. It carries an expense ratio of 0.35% of assets, meaning that for every $1,000 invested, about $3.50 of fees are subtracted from its assets each year ($1,000 × 0.35% = $3.50). While the expenses you'd incur by owning it are not excessive, since the 10 largest stocks make up more than 60% of its portfolio, you aren't getting a lot of diversity for the annual cost, either.
2. Regional banks
These "midsize" banks are large enough to compete in a large geographic region like a state or several states. Unlike money center banks, which collect deposits and make loans on different sides of the country and even across national borders, regional banks tend to draw in deposits and make loans to customers in one geographic area.
Being in the middle of the pack, regional banks span from large "super-regional" banks with $100 billion or more in assets, down to smaller institutions that have as little as $1 billion in assets. All three of the banks below are regional banks, though the largest is more than 100 times bigger than the smallest.
Regional banks can be thought of as somewhat of a blend between larger national money center banks and community banks. On one hand, their larger balance sheets and geographic reach give them some diversification and the conveniences of national banks (more branches and ATMs, for instance). On the other hand, these banks make their money mostly in traditional businesses like lending to consumers and businesses rather than advising billion-dollar tech companies on the best route for going public.
Why invest in regional banks?
Regional banks are often said to be in the "sweet spot," large enough to finance midsize businesses, but often small enough that their fortunes are tied to a specific geographic region rather than to the ups and downs of national or international economic forces.
Here's why investors might decide to invest in regional banks:
- Interest rate wagers: Regional banks are generally the banks to buy if you believe interest rates are likely to rise. The reason is relatively straightforward: Regional banks typically underwrite more floating-rate loans than other banks, and as a result, the interest income they earn rises or falls with the market rate of interest. In addition, compared to national banks, regional banks typically earn more of their income from interest rather than fees. Thus, because interest drives a larger portion of their revenue, changes in interest rates have a larger impact on their earnings.
- More growth opportunity: The largest banks in the United States may be "too big to fail," but that also means they're too big to grow very fast. Regional banks can grow by acquisition and by organic branching (de novo branching, in banking parlance). Even the largest regional bank, U.S. Bancorp, is roughly one-sixth the size of JPMorgan Chase, which just goes to show that these banks are still pretty small fish in a very big pond.
- Simplicity: Though the largest regional banks are quite large, they certainly aren't global investment banks you'd find on Wall Street. Most regional banks earn their money in the relatively simple business of taking deposits and making loans. Regional banks blend the lending exposure of community banks with the cost efficiency of large national and money center banks.
The risk of investing in regional banks is that they generate a greater share of their earnings from lending. Though that makes them better for investors who want stocks that benefit from rising rates, it also means they don't have the stable fee sources that the largest banks have. Thus, their earnings tend to be more sensitive to interest rate movements, as well as economic conditions. If the economy contracts, unemployment ticks up, or real estate prices dip, regional banks, which make more of their money from lending, would be harder-hit than larger banks with diversified income sources.
The only regional bank ETF worth owning
When it comes to regional bank ETFs, the SPDR S&P Regional Banking ETF (NYSEMKT: KRE) reigns supreme as the largest by assets and daily trading volume. Its popularity isn't an anomaly; the fund offers a really attractive way to buy into a large swath of regional banks thanks to the way in which it selects and invests in bank stocks in its portfolio.
The ETF's "secret sauce" is that it uses a modified equal-weighted approach to constructing its portfolio. Put simply, whereas many ETFs invest more in the largest banks by market value, this ETF invests roughly the same amount in every bank, regardless of its market value. Thus, each bank makes up a roughly equal portion of its assets so that the performance of the smallest regional bank has just as much of an impact as the largest.
At the time of writing, the SPDR S&P Regional Banking ETF held 127 different companies, none of which made up more than 2% of its assets. It's a true "midsize" bank ETF, as mid-cap and small-cap bank stocks make up 56.5% and 26.6% of its assets, respectively, according to Morningstar.
With an expense ratio of 0.35% of assets, this ETF is relatively cheap considering its diversified portfolio and its strategy. Equal-weighted funds do a lot more trading than market-cap-weighted funds because they take profits in stocks that have gone up in value, and buy more of stocks that have declined in value, to ensure that all stocks are weighted equally. Replicating this portfolio and strategy would cost most investors way more than 0.35% per year in commissions if they tried to manage their own portfolio of 127 equally weighted banks ($5 a trade to manage a portfolio of 120-plus stocks adds up fast).
Notably, of all the bank ETFs we'll profile in this article, the SPDR S&P Regional Banking ETF has one of the longest track records (it was launched in 2006) and the highest performance over the trailing-10-year period. That isn't necessarily surprising. Its equal-weighted approach and focus on community banks helped it dodge the biggest banking blowups during the 2008 financial crisis.
3. Community banks
The smallest of banks, community banks generally operate in very small, localized areas, no bigger than a single city or metropolitan area comprising little more than a handful of counties. According to the Federal Deposit Insurance Corporation (FDIC), "community banks are three times more likely than other banks to be headquartered in a rural area or a micropolitan area with populations between 10,000 and 50,000 people than are non-community institutions." That sums up the vibe of the typical community bank pretty well.
Community banks are simple banks. They take in deposits in one small geographic area and lend them out to people and businesses in the same area. Lending is about all they do. In fact, according to data compiled by the FDIC, about 70% of community banks' assets are loans, versus 53% for non-community banks.
Why invest in community banks?
Community banks operate in a world completely different than that of money center banks or larger regional banks, as their loan exposures rarely go much further than their own school districts or city limits. Here's why investors might want to invest in community banks:
- Localized exposure: A community bank's success or failure is a byproduct of economic conditions in the geographic area immediately surrounding its branches. What happens on a global or even a national scale is less important to a community bank than it is to a regional bank or money center bank. California could slide into the Pacific Ocean, aliens could destroy Manhattan, and Lake Superior could flood all of Wisconsin, but a bank in Topeka, Kansas, is unlikely to feel any shockwaves in its local loan portfolio.
- Acquisition riches: Community banks are compelling acquisition targets for regional banks and rival community bankers. A regional bank can buy up a community bank, keep most of its customers and lending relationships, while closing most or all of its costly branches. In July 2018, there were 25 transactions involving banks with less than $1 billion in assets. That trend is likely to continue for years to come, as smaller banks pair up to reduce costs, and larger banks acquire small banks for growth.
- Informational advantages: Smaller banks simply know more about their local economy and their customers than megabanks, and they can use this knowledge to their advantage. An FDIC study of loan performance from 1991 to 2011 found that community banks "may ... do a better job of underwriting loans than noncommunity institutions" because of their local ties. The outperformance in commercial real estate loans was particularly strong when prices dropped, as "loan loss rates were much higher at noncommunity banks than at community banks during real estate downturns, when loss rates rose."
Community banks have been a favorite way to bet on a future with fewer banks, as some will get acquired at large premiums, while those that remain benefit from fewer competitors in their communities. A trend toward fewer and fewer banks is well established, as the number of commercial banks in the United States declined from 14,400 banks in 1984 to about 8,500 banks in 1999, and about 4,800 banks as of June 2018.
The biggest risk with community banks is that they typically compete for the smallest loans, such as single-family mortgages, auto loans, or personal loans, which require less credit expertise, and attract more competition. Increasingly, community banks are also competing with credit unions, which have no profit motive and therefore, in many cases, can afford to pay higher rates for deposits and issue loans at lower rates than for-profit community banks.
An ETF for the smallest banks
There are hundreds of banks on U.S. markets, most of which are very small and trade infrequently. Getting exposure to these smaller banks is difficult, but First Trust NASDAQ ABA Community Bank Index Fund (NASDAQ: QABA) offers a very thoughtful way to buy them as part of an ETF.
This index fund selects stocks by starting with all Nasdaq-listed banks and thrifts. It then eliminates the 50-largest banks by assets (this isn't an ETF for giant bank exposure, after all), as well as any banks with a market cap less than $200 million (to avoid banks that it can't buy or sell without moving the market).
The banks that remain (roughly 170 at any given time) are then weighted by market cap so that the largest of the smallest banks make up the largest part of the portfolio. But don't be fooled by its market-cap weighting, as this fund skews toward seriously small banks.
Small- and micro-cap bank stocks make up 51% and 11% of this bank ETF's assets, respectively, according to data from Morningstar. That's more than twice as much small-bank exposure as the aforementioned SPDR S&P Regional Banking ETF, which itself skews rather small.
This bank ETF is relatively costly to own, given its expense ratio of 0.60%. Of course, with nearly 170 stocks in the portfolio, recreating this ETF on your own would cost most investors far more in commissions. Plus, it's a relatively unique ETF, as there aren't any real competitors that invest in banks as small as this ETF does.
The all-in-one bank ETF
So far, we've discussed how to invest in banks based on their size. Understandably, some investors may just want to own as many banks as possible, large, medium, or small in size, and do it without paying out the nose in expenses to do it.
For the bank investors who just want to own as many banks as possible, across the spectrum, there's a perfect ETF for you: the SPDR S&P Bank ETF (NYSEMKT: KBE). This ETF is nothing fancy. It simply seeks to track the S&P Banks Select Industry Index, which is comprised of banks sifted from the total stock market.
The SPDR S&P Bank ETF is all-inclusive, as it owns ordinary commercial banks, thrifts (consumer banks), mortgage finance businesses, and custody banks, which are banks that exist as bookkeeping services for mutual funds, pension funds, and other investors. The ETF only invests in companies with a float-adjusted market capitalization in excess of $2 billion, meaning that a company must have at least $2 billion of stock available for trading on an exchange. The ETF weights its positions through a modified equal-weighted approach, so that bank stocks are weighted roughly equally.
Think about it this way: If you lined up all bank stocks with market caps of more than $2 billion and invested an equal amount in each one, you'd end up with a portfolio very similar to SPDR S&P Bank ETF. With 85 different holdings and an annual expense ratio of 0.35%, this is a set-and-forget bank ETF that gives you exposure to banks of all shapes, sizes, and business models.
The bottom line on bank ETFs
Bank stocks can be rewarding investments. First, banks are prolific dividend payers, as only the very rare, ultra-fast-growing banks do not pay recurring quarterly dividends to their investors. It's actually quite difficult to find a bank that doesn't pay a dividend, as even the smallest banks generate more in income than they can reliably invest to support deposit and loan growth.
Secondly, bank stocks are among the rare investments that actually benefit from a rising-rate environment. While higher interest rates invariably weigh on stock and bond valuations, banks tend to see their earnings grow rapidly when interest rates are increasing, because they earn larger spreads between their deposit costs and their loan yields.
Of course, the banking industry isn't without its risk. A bank's earnings power will largely follow that of the economy in which it operates, and across the sector, earnings are highly cyclical. In periods of robust employment and strong economic growth, banks virtually print money, as loan losses are low and interest rates are typically rising. However, in recessions, loan losses inevitably consume a greater share of their would-be earnings.
But through the ups and downs, bank investors can earn attractive returns. Investing in the industry with any one of the four bank ETFs profiled above would be a good way to get started in this all-important corner of the market.
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