The Latest Threat to Big Bank Stocks?

Exchange-traded funds are supposed to make things simpler for investors by giving them a one-stop shop to get exposure to certain sectors. But with ETFs now having more than $1 trillion in assets, they're a big enough force in the marketplace to pose the risk of causing unintended consequences that can mean big trouble for the stocks they own.

In the most recent example of this phenomenon, already-beleaguered financial stocks find themselves at ground zero of a shake-up in the ETF universe. With some major financial ETFs making big changes, do bank shareholders need to prepare for what could be a massive upheaval?

What's in an index?
The controversy involves five SPDR ETFs that track various parts of the financial sector. The largest by far, SPDR S&P Bank, has assets of over $1 billion and includes most of the best-known banks in the country, while others cover segments including insurance companies and regional banks.

The challenge that State Street's (NYSE: STT) Global Advisors division, which manages the SPDR ETFs, currently faces is that the ETFs tracked indexes from a third-party provider, KBW. But the licensing agreement under which the SPDRs used the KBW indexes ran out, and rather than renewing the agreement, SSgA decided to switch the tracking indexes on these SPDR ETFs to ones that McGraw-Hill's (NYSE: MHP) Standard and Poor's division developed. KBW, on the other hand, intends to develop its own line of competing ETFs based on its own indexes.

Ordinarily, this wouldn't be a huge deal. But as it turns out, S&P's bank indexes are a lot different from KBW's. In particular, with the SPDR Bank ETF, KBW used a market-cap weighted methodology to balance components, causing the biggest banks to dominate the rest of the index. Take a look at the weights of the five biggest banks in the ETF as of Sept. 30, when the ETF tracked the KBW index:

Source: State Street Global Advisors. As of Sept. 30.

By contrast, after the change, the ETF's holdings are all roughly equal-weighted. That reduces the total share of assets of those five banks from nearly 40% to only about 13%.

What's the big deal?
Ordinarily, major index changes like this can have a massively disruptive impact on the stocks involved. Because an index shift is a one-time event that puts pressure on index-tracking institutions to make quick changes in order to avoid tracking error, the trading that institutions have to do to get back in line with a new benchmark can push stock prices sharply in either direction.

Fortunately in this case, the biggest stocks involved in the index change all have very high daily trading volume. That means that their markets are liquid enough so that even a big move in a billion-dollar ETF hasn't made noticeable waves in an already volatile market. In fact, given the huge jump in the overall stock market on Thursday -- a jump that particularly helped financial stocks of all sizes -- any impact of the move will likely get lost in the noise of trading activity.

But more generally, the controversy raises the specter of future, more significant problems down the road. With plenty of ETFs that are much larger than the SPDR Bank ETF, the potential systemic risk involved in a fund's licensing agreement with the index it tracks might not have been on the radar screens of investors and regulators before now.

What you can do
One of the elements of due diligence you should do before buying an ETF is to look at its arrangement with whatever entity has the rights to the index the ETF tracks. In the best case, the ETF provider will have control of the index itself. When that's not the case, though, ironclad agreements can help minimize any uncertainty about what could happen down the road if the tracking index has to change.

Some sector ETFs have index-related risk, but the right ones can still be moneymakers in an improving economy. Find out about three ETFs that are poised to rise in a recovery in a special free report from the Motley Fool.