Most Canadians likely have ample exposure to the domestic financial services sector, which is dominated by the big banks, through broad-based Canadian equity funds. But for those who like the prospects of the banking sector but would like to add geographic diversification to their portfolios, 
SPDR S&P Bank ETF (KBE) provides an interesting option. This narrowly focused exchange-traded fund tracks the S&P Banks Select Industry Index, which contains 61 banks based in the United States.
S&P applies equal weighting to the index's holdings, though it makes adjustments where necessary to ensure adequate liquidity. That means the portfolio is neither concentrated nor dominated by large banks such as Bank of America (BAC) and JPMorgan Chase (JPM).This equal-weighting approach can create higher turnover than a comparable fund tracking a market-cap-weighted index. In fact, the fund's turnover was 29% for the year ended December 2014. S&P rebalances the index quarterly.
The equally weighted portfolio also gives KBE a mid-cap tilt; small- and mid-cap companies represent 85% of the portfolio. Consequently, its holdings' average market cap is only US$6.7 billion. Unlike broad financials-sector funds, KBE excludes non-bank financial institutions such as REITs and insurance companies. As a result, it tends to be slightly more volatile than its more diversified sector peers.
Although most traditional deposit banks in the United States hedge a portion of their interest-rate risk, they are especially sensitive to changes in the shape of the yield curve. A flatter yield curve reduces the spread between the rate at which banks can borrow and lend because they fund most long-term loans through short-term deposits. A steepening yield curve tends to have the opposite effect. Consequently, KBE is an appropriate tactical satellite holding for investors who have a high risk tolerance and want to bet on a steepening yield curve and further improvements in the U.S. banking sector.
Unlike many other United States equity sectors, the financial-services sector still has not come back to its pre-financial-crisis highs. The reasons for this have been well-documented, including greater regulation, continued ultralow interest rates, asset write-downs and higher capital requirements. As a result, investors in KBE are faced with considerable risks to the U.S. economy, given that small changes in unemployment and consumer confidence can have a significant impact on loan repayment rates and willingness to borrow. The strength of the housing market can also have a large impact on borrowing and default rates. Adding to these risks, commercial banks and thrifts face an unfavourable regulatory environment, rising capital requirements and low interest rates, which may limit their profitability and increase competition.
During the past five years, KBE has had a standard deviation of 18.4%. That's much higher than the 11.9% volatility that the S&P 500 has displayed during that period, and it's also slightly above the 15%-16.5% volatility levels that broad U.S. financials ETFs have displayed during that same period.
Fundamental View
U.S. banks have outperformed the broader U.S. equity market in 2015. Credit quality has been excellent, and investors once again are optimistic about the prospect of rising interest rates and their impact on the banking sector. Banks also have enjoyed relative calm, with no bad news, no major credit issues in energy and most financial crisis-related settlements concluded.
Ongoing low interest rates have continued to pressure banks' net interest margins. Higher rates may well be a longer-term tailwind for banks, but any immediate benefit from an interest-rate hike would be muted at best, as higher rates will not translate one-for-one into higher earnings for banks. Bank earnings and valuations are driven more by net interest margins, which are more stable over time, than by interest rates. Morningstar's equity analysts don't expect banks' interest-spread revenue to grow anytime soon. Instead, they believe low loan yields will cause interest-spread revenue to stay flat or even decline.
While large banks are far better capitalized than they were before the financial crisis, the March 2015 annual Federal Reserve stress test for 31 large U.S. banks still raised concerns about some large lending institutions. While many big banks, including Citigroup (C) (which had failed one of the tests in 2014), passed the stress test, Bank of America was ordered to resubmit its capital plan owing to some unspecified deficiencies. As expected, the U.S. trust operations of two major European banks, Deutsche Bank (DB) and Banco Santander (SAN), failed as well. On top of those concerns, banks continue to face a prominent headwind in the form of elevated compliance, regulatory and legal costs across the industry, which continue to hit banks' income statements. To counteract lower spread revenue and tighter margins, banks continue to reduce expenses, including cutting staff and branch locations.
U.S. banks have positioned themselves well for the future; stress tests show that banks generally are better capitalized now and can withstand serious economic shock. As a result of the aggressive steps banks have taken to recapitalize after the financial crisis and as a result of conservative underwriting in recent years, banks' capital ratios are improving. A stronger housing market also has lessened the need for reserves, allowing banks to reduce provisions for loan losses. (Banks broadly have had modest success growing their balance sheets.)
Also affecting banks' profitability of late are limited debit-card fees, higher compliance costs and increased regulation blocking banks from taking deposits and engaging in proprietary trading. Lower unemployment has been a benefit, as unemployment generally keeps borrowing and repayment rates low.
KBE charges a 0.35% expense ratio, which is reasonable for its niche exposure. However, there are cheaper broad financials-sector ETFs available. KBE's average daily trading volume of 1.6 million shares helps keep its bid-ask spread tight and the market impact of trading low.
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