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Bank on recovery with this cheap ETF Add to ...

With the economy expected to continue improving and with banks' improved capital position, the financials sector is not as risky as it was from 2007-09.

The large money-center banks that experienced the most pain in the downturn are poised to be the biggest beneficiaries during the recovery. The SPDR KBW Bank ETF is our preferred choice in the financials sector because of its focus on large-cap banks.

The larger and more popular Financial Select Sector SPDR owns real estate investment trusts, insurers, investment banks, and credit cards issuers, in addition to banks. These other areas of the financials sector are not as well positioned to succeed as are the money-center banks in the current environment.

The KBE offers exposure to a relatively concentrated portfolio of the 26 national money-center and super-regional banks in the KBW Bank Index. Large institutions such as J.P. Morgan Chase , Citigroup , and Bank of America can be found here, along with large regional banks such as SunTrust and Fifth Third Bank . KBE is very volatile. Investing in the financials sector requires strong risk tolerance and the understanding that the sector is will be susceptible to setbacks if the economy falters.

From a valuation perspective, KBE is still attractive, with a price/fair value multiple of 0.88, compared with 0.94 for the Standard and Poor's 500 index. Banks are not the deeply discounted securities they were a year ago but they are still attractive relative to the general market. The current steep yield curve will only help earnings further, because banks can take in deposits at low rates and lend the money at higher long-term rates. Earnings may never recover to 2006 levels but, at the current discounted valuation, they don't need to for KBE to be an outperforming fund over the next few years.

Although this fund invests only in banks, the banks steering its performance have their fingers in just about every financial-services business under the sun (think credit cards, investment banking, asset management, securities trading, and so on). The immensely complex nature of these banks, coupled with their sprawling geographic reach and counterparty exposures, turned out to be the banks' Achilles heel once economic reality finally set in. With the financial crisis in the rearview mirror, these diverse businesses give the large banks an advantage over their smaller rivals, which rely on just the traditional banking model.

Most of the large money-center banks have repaid government loans and are very well capitalized. In the next few weeks, the Federal Reserve will be doing a second round of stress tests on the major banks. If the banks pass these tests, they will likely be allowed to raise their dividends.

The Morningstar financials team performed its own stress test similar to the methodology the Federal Reserve will use. Of the 14 financial institutions in the KBE, 13 passed the tests. The only failure was Regions Financial , which only has a 4 per cent weighting in the fund. Assuming the Federal Reserve comes to similar conclusions, we can expect major dividend increases in 2011.

The major banks are highly leveraged to the US economy, so we are encouraged by the recent string of strong economic news. The slowly improving economy should act as a tailwind for the improving earnings of US banks. This fund levies an expense ratio of 0.35 per cent, which is very reasonable.

Paul Justice is director of North American ETF research and editor of Morningstar ETF Investor and Timothy Strauts if an ETF analyst

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