Regional banks have been the laggards within the broad financial sector for much of 2014. This space has been a weak player as interest rates in the U.S. have remained at rock-bottom levels this year despite the Fed continually scaling back its QE program.
The Fed’s continued assertion to keep interest rates lower have led to a narrowing spread between long- and short-term rates, thereby hurting the net interest margin earned by banks.
Regional banks usually benefit from a widening spread between long- and short-term rates as they make money from paying interest on short-term deposits while receiving payments from longer term securities like mortgages.
Fed’s Latest Comments
The Fed in its latest policy meet maintained its prior stance and said that rates would stay low for a ’considerable time’ even after the bond buying program ends. Though the Fed declined to clarify the length of time it considers ‘considerable’, many officials believe it is roughly six months, indicating that rates would start rising by mid next year.
Though the Fed did indicate that rates would rise faster than previously expected once it starts raising rates, the central bank's firm commitment to keep interest rates near-zero led to the decline in rates, pushing down both mid-term and long-term Treasury yields.
In fact, five-year government debt, which was trading around the 1.85% level as on September 18 (the day of Fed policy outcome), had plunged to a low of 1.78% two days after the announcement, before rising above the levels of 1.80% lately.
Given the Fed’s latest dovish comments and a decline in rates, spreads are likely to remain compressed for a while. As such, regional banks might continue to see sluggish trading in the near time, until the Fed changes its stance in its next meet. Though a hike in rates is ultimately inevitable, we believe that it is better to stay on the sidelines and avoid regional banking ETFs for now.
Below, we have highlighted some of the funds for investors who are curious about this space and the funds that will likely be impacted by the current trends in the market:
SPDR S&P Regional Banking ETF (NYSE:KRE)
This is one of the largest and the most popular ETF in the banking space with an AUM of nearly $2.4 billion and average daily volume of roughly 2.9 million shares.
The product follows the S&P Regional Banks Select Industry Index, charging investors 35 basis points a year in fees. The product holds a well-diversified basket of 83 stocks. It uses an equal-weighted strategy and hence minimizes concentration risks. None of the individual stocks form more than 1.6% of total fund assets.
The fund currently has a Zacks ETF Rank #4 or Sell rating and has lost 4.3% in the year-to-date frame (see all the Top Ranked ETFs here).
iShares DJSU Regional Banks Index (NYSE:IAT)
IAT tracks the Dow Jones U.S. Select Regional Banks Index to provide exposure to small and mid-size U.S. banks. The product holds a small basket of 54 stocks and is quite heavily concentrated in its top three holdings, which together form 40% of allocation. The top holding US Bancorp alone has 20% exposure in the fund.
The fund manages an asset base of $479.4 million and trades in moderate volumes of roughly 96,000 shares a day. IAT charges 46 basis points as expenses and has returned 2.9% in the year-to-date frame.
PowerShares KBW Regional Banking (NYSE:KBWR)
KBWR is another option in this space, though it is less popular and relatively illiquid with an asset base of $96.7 million and an average trading volume of less than 10,000 shares a day (see all the financial ETFs here).
The product holds a basket of 50 companies, mostly from the small cap space. The fund does a great job in diversifying its assets well among individual holdings as none of the stocks have more than 4% exposure.
KBWR currently carries a Zacks ETF Rank #4 or ‘Sell’ rating and has lost roughly 5% this year.