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-Gloria Nieto/The Globe and Mail

Banks, banks, banks: The obsession Canadians have with bank stocks is understandable, but is it smart investing?

The banks dominate our city street corners with the branches, and our benchmark stock indexes with their shares. Four of the 10 largest stocks on the S&P/TSX composite index are banks these days. But, arguably, you're better off investing in the entire financial sector and not focusing just on banks. That's the conclusion to be drawn from a little ETF showdown I staged recently. In one corner, the BMO S&P/TSX Equal Weight Banks Index ETF (ZEB-T), which is an efficient way to get the Big Six banks into your portfolio with a single security. In the other, the iShares S&P/TSX Capped Financials Index ETF (XFN-T), which has 71 per cent of its assets in the big banks, 24 per cent in insurance and the remainder in "diversified financials," including Onex Corp. (OCX-T) and TMX Group (X-T).

The annualized five-year total returns for both ETFs is a tie at 10.1 per cent. Over the three years to July 31, XFN's 15.9 per cent return beats ZEB's 13.1 per cent. The appeal of XFN's superior diversification becomes even more apparent when you start looking at the past 12 months or so, a period of weakness for bank stocks. ZEB lost 5.1 per cent for the 12 months to July, double the loss for XFN.

Let's not fool ourselves about XFN – it's mainly a bank play. But you do get a modest amount of exposure to the shares of big financial players like Manulife Financial (MFC-T), up a cumulative 77 per cent over the past five years, and Sun Life Financial (SLF-T), up 74 per cent over the same period. The best of the banks over that period was Royal Bank of Canada (RY-T), up 48 per cent. The rest ranged from 46 per cent for Toronto-Dominion Bank (TD-T) to 23.5 per cent for Bank of Montreal (BMO-T) and Bank of Nova Scotia (BNS-T).

The appeal of an all-bank approach is that you're buying a known commodity renowned for dividend growth and dividend security. No Canadian big bank cut its dividend during the financial crisis and its aftermath, though Manulife did. But adding some other financials to your mix – insurers and the likes of Onex and TMX -- can help take some of the sharp edges off the volatility of bank stocks. Own them for sure, but diversify.

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