The KBW Bank Index Explained

If you follow bank stocks and big bank stocks, in particular, you should get acquainted with the KBW Bank Index, which tracks two dozen large-cap bank stocks. I refer to it frequently when I write, and therefore want to give readers a brief overview of exactly what it is, and why investors should care about it.

The best way to think about the KBW Bank Index is to analogize it to the S&P 500, which tracks shares of 500 publicly traded companies with the largest market capitalizations in the United States. But instead of being industry agnostic, as the S&P 500 is, the KBW Bank Index focuses on only large-cap banks -- 24 of them, to be precise.

These are banks that you've no doubt heard of, including JPMorgan Chase (JPM +0.96%), Bank of America (BAC +0.73%), Wells Fargo (WFC +2.19%), and Citigroup (C +1.41%). These are the four biggest banks in the country. They're also -- with the exception of U.S. Bancorp (USB +0.31%), the best-run big bank in the country -- the four that are weighted most heavily on the KBW Bank Index.

The index weights its components according to a measure of market capitalization, adjusted for a bank's share price. This helps to explain why, as you can see in the table below, Citigroup carries the greatest weight on the Index, even though it has a smaller market capitalization than JPMorgan Chase, Wells Fargo, and Bank of America, respectively.

Source: Invesco.

There's one side note that's worth pointing out when it comes to the KBW Bank Index. That is, not all of these banks have the same business model. Some are universal banks, which operate both investment and commercial-banking operations. JPMorgan Chase, Bank of America, and Citigroup fall most comfortably into this category.

A second group consists of so-called custodial or trust banks. The three banks on the list that most naturally fall into this category are State Street, Northern Trust, and Bank of New York Mellon -- and I consider the latter to be a particularly interesting bank. These banks focus less on making loans and taking deposits and more on the administration of fixed-income securities for institutional investors like hedge funds, university endowments, and insurance companies.

The final group are pure-play commercial banks, specializing in taking deposits and making loans. When most people think about a bank's business model, this is what they have in mind. The largest among these is Wells Fargo, followed by U.S. Bancorp, PNC Financial, and Capital One Financial, respectively.

Image source: Getty Images.

An index like this is important for investors because it allows you to see whether a particular stock is in line with its peer group. Viewed in isolation, it's impossible to say whether a particular bank stock is cheap or expensive -- or efficient or inefficient -- or whatever metric it is that you're trying to tease out.

But if you have a control group against which to compare a bank's valuation, profitability, or efficiency, then you can get a much better idea of its relative value or performance, which explains why I can confidently say that U.S. Bancorp is the best-run big bank in the country. This is what the KBW Bank Index enables one to do. And it's why I recommend that investors have a general understanding of what it is and how to use it.