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You Don't Have to Pick a Winner Among Banks. Here's Why.

Motley Fool - Thu Jun 15, 5:55AM CDT

You may have noticed, but banks have been in the news just a bit this year -- and by just a bit, I really mean a lot -- in the financial press, at least. But it appears the worst of it may be over following the collapse of three major banks in March and April.

Still, there are lingering issues that affect some banks more than others. There are also economic headwinds for banks to deal with, particularly if the economy turns south.

Investors are faced with a conundrum, because there are many great deals in the banking industry after the sell-off -- but there are still many banks that are struggling. If you're looking for good deals in this sector but don't want to take the risk of picking individual stocks, consider investing in an exchange-traded fund (ETF) that tracks the banking industry.

Seeking bargain banks

ETFs are baskets of stocks that act like mutual funds but trade like a stock. While there are actively managed ETFs, most are passively managed and track an index, sector, industry, or investment style.

There are thousands of ETFs, so you can find one that pretty much covers any niche you're looking for. For example, if you're interested in banks, there are a handful of ETFs that invest in the banking industry, from those that track the broader industry to those that invest in regional or community banks or just large banks.

Most of the volatility we've seen this year has come from community and regional banks. There are remaining issues, as smaller banks could face additional regulation or consolidation. U.S. Treasury Secretary Janet Yellen recently commented on the need for consolidation among smaller banks, especially those facing earnings pressures.

On the other hand, she also noted that large banks have the strength to weather the storms, as they must pass rigorous annual stress tests given by the Federal Reserve to ensure they can handle a shock to the system. "My overall read is that the level of capital and liquidity in the banking system is strong and while there will be some pain associated with this, the banks should be able to handle the strain," Yellen said.

Given those factors, the best, safest bank ETF to invest in might be the SPDR S&P Bank ETF(NYSEMKT: KBE).

A diversified bank ETF

The SPDR S&P 500 Bank ETF is probably the most diversified among the bank ETFs as it tracks the S&P Banks Select Industry index, which includes banks of all sizes within the larger S&P Total Market index. It also contains a wide variety of banks, including asset management and custody banks, diversified banks, regional banks, diversified financial services, and commercial and residential mortgage finance companies.

The other great diversifier for this fund is its modified equal weighting, meaning all stocks have roughly the same weight in the portfolio. Overall, the ETF holds about 94 stocks, with First Citizens BancShares, New York Community Bancorp, and MGIC Investment Corp as the three largest holdings. As of June 9, each one was slightly more than 2% of the portfolio, with big banks like JPMorgan Chase, Wells Fargo, Bank of America, and Citigroup all within 1.6% and 1.8% each.

Over the past year, as of May 31, the ETF is down about 29%, but it has a three-year annualized return of 5.6% and a 10-year annualized return of 4%. These aren't great numbers, but the industry just went through a major shock, and bank valuations are very cheap. The price-to-book ratio for the fund is 0.95, so the ETF is trading below the book value of the stocks in the ETF.

In other words, it's not a bad time to tap into banks at this cheap valuation because they are cyclical. When the next bull market runs, banks should ride with it.

If you're interested in cheap banks with growth potential, buying a basket of them in an ETF might be a better option than trying to pick the individual winners.

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JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Wells Fargo is an advertising partner of The Ascent, a Motley Fool company. Citigroup is an advertising partner of The Ascent, a Motley Fool company. Bank of America is an advertising partner of The Ascent, a Motley Fool company. Dave Kovaleski has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Bank of America and JPMorgan Chase. The Motley Fool has a disclosure policy.

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