The regional bank sub-sector of the financials is lagging the large money centers in 2012. However, it is still outpacing the return of the S&P 500. The regional banks ran into issues during the financial crisis, but did not have the same type of exposure to the complicated derivatives as their larger peers.

Since the beginning of 2011 the SPDR Financial ETF (ARCA:XLF) has fallen by roughly 6.7% versus a gain of around 2% from the SPDR S&P Regional Banking ETF (ARCA:KRE). The charts are also very different between the two ETFs. KRE recently hit a fresh 22-month high as XLF has yet to breakout to a new 52-week high. While KRE is comprised of smaller regional banks, XLF is a basket of the largest banks in the U.S.

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Regional Bank ETFs
There are 76 stocks that make up KRE, with a weighted average market capitalization of about $3.7 billion. The portfolio trades with a P/E ratio of nearly 14.2 and the current dividend yield is approximately 1.6%. The makeup of the ETF is conducive to investors that prefer diversification and want exposure to the entire sector. Zions Bancorp (Nasdaq:ZION) and Huntington Bancshares (Nasdaq:HBAN) are the two largest holdings and make up only around 3.77%, combined. The expense ratio for the ETF is a reasonable 0.35%.

Another competitor in the sector is the iShares Dow Jones Regional Bank ETF (ARCA:IAT), which is down over 4% from the beginning of 2011. The performance of the ETF is in-line with the larger banks, but lagging KRE substantially. The reason for the difference in performance is the makeup of the ETF. Whereas KRE is extremely diverse, IAT is concentrated on a few of the top holdings. U.S. Bancorp (NYSE:USB) is the top holding with nearly 21% of the allocation, followed by PNC Financial Services (NYSE:PNC) with almost 12% of the ETF. With one-third of the portfolio in only two stocks, investors do not achieve the true diversification that is often the goal of an ETF.

There are 62 stocks in the ETF, which charges an expense ratio of 0.47%. The dividend yield is about 1.7% and the ETF trades with a P/E ratio of roughly 12. Even though the valuations are similar for KRE and IAT, the makeup is extremely different, as are the returns for investors. Of the two ETFs, KRE is a true regional bank ETF and would be my choice in the sector.

The Importance Of Diversification

The Bottom Line
The biggest risk to the regional banking sector would be a repeat of last summer, when issues in Europe rose to the headlines. Even though the prolonged troubles in Europe will not directly affect most regional banks, the spillover affect could hurt the sector. It is important to monitor the situation in the coming weeks, if you decide to buy into any of the related ETFs or stocks.

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At the time of writing, Matthew McCall did not own shares in any of the companies mentioned in this article.

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