So far, 2023 has been a very bad year for banks. And yet the poor performance of the sector might be exactly what attracts some investors. Indeed, contrarians are always on the lookout for situations when Wall Street seems unduly pessimistic. If you are thinking about banks, here are three exchange-traded funds (ETFs) to consider that allow you to avoid company-specific risk.
An ugly year for banks
When investors think about the Great Depression, one of the first things to come to mind, after the massive stock losses, is bank runs. They were common then, but they are not common now, thanks largely to government regulation and the Federal Deposit Insurance Corporation, which was created to protect bank customers. So when several banks experienced bank runs in early 2023 it was a bit of a shock. Even worse, some regional banks actually failed because of the bank runs.
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The entire banking sector got hit on Wall Street, and perhaps for good reason. While the bank failures were fairly specific to the focused approaches taken at the banks that failed, there is an overriding problem that all banks are facing. Specifically, banks are allowed to hold bonds on their balance sheets at face value if they intend to own them until maturity. But those bonds are usually meant as a backstop against adversity, like when too many depositors demand their cash back all at once (which is a bank run). If the bank needs to sell those bonds, it has to accept market value for them.
Here's the problem: Many of the bonds banks own were bought before interest rates started to rise. And thus those bonds aren't worth less than face value. For large and financially strong banks this probably isn't a big deal, as long as the banks can avoid selling the bonds. For smaller banks and financially weak ones -- well, there's a real risk of having to sell at a loss. In that case, the bank's finances will turn out to be much worse than what the balance sheet suggested. This is basically what resulted in the bank collapses early in the year.
This is also the risk investors face in buying individual banks today. And why an exchange traded fund might be a better option, since you don't have to select a single bank stock and pray you got it right.
Three ETF options to consider
There are a number of ETFs in the bank sector, but three stand out for their unique portfolio focuses. The first one to look at is probably SPDR S&P Bank ETF (KBE -0.31%). This ETF is basically a way to own the entire banking sector for a fairly reasonable price, given its 0.35% expense ratio. Notably, the portfolio is equally weighted, so large stocks and small stocks will have the same impact on the ETF's performance.
Roughly 68% of the portfolio is invested in regional banks, which makes logical sense given the equal weighting approach. About 15% is in diversified banks, with the rest in more specific types of banks, like investment banks. That regional bank exposure might worry you, given that's likely where the most risk lies in the bank sector. However, it's also where there is the most pessimism, so there's potentially more opportunity for recovery as well. The equal weighting, meanwhile, will limit the negative impact that any single company has on the overall portfolio. And the rest of the portfolio helps to diversify performance.
However, this brings up two other choices you have. If you want to double down on the trouble spot, an aggressive contrarian stance, you can buy SPDR S&P Regional Banking ETF (KRE -0.58%). This ETF owns exactly what its name says, again with an equal weighting approach. The expense ratio is also 0.35%. Going in, investors need to recognize that regional banks come with more risks on a normal basis because of their often modest sizes. The risks are just elevated today because of fast rising interest rates and the bank run issue.
Going the opposite direction, investors could look at Roundhill Big Bank ETF (BIGB). This is a fairly new and still rather small ETF, but it is focused on owning big banks. In this case, that's just the six largest banks in the United States. These banks have held up relatively well in the face of this year's banking troubles. Like the two other ETFs here, Roundhill Big Bank ETF uses an equal weight approach. The expense ratio is 0.29%.
Basically, you have three options here. SPDR S&P Bank ETF covers the broad banking sector. SPDR S&P Regional Banking ETF gives you exposure to just regional banks, which is probably where the most upside recovery potential exists. And Roundhill Big Bank ETF provides a way to invest in just the largest banks in the U.S. market, which are likely to be the safest banks to own in most situations.
Only appropriate for more aggressive investors
Here's the thing: Just because you can do something doesn't mean you should do it. And that's the big caveat with these banking sector ETFs. Most investors will probably be better off focusing on ETFs that are far more diversified, like an S&P 500 index ETF. But if you have a contrarian streak and are willing to take an aggressive investment stance, you don't have to pick individual winners and losers in the banking sector. You can go with industry-focused ETFs that let you slice and dice the banking industry in whatever way best suits your tastes.
