Small-cap bank stocks are those of regional and community banks or thrifts, firms that are minuscule in comparison to major money center banks, such as Wells Fargo & Company (NYSE: WFC). There are a couple of strong reasons for investors to consider getting exposure to small-cap bank stocks.

In 2016, it appears that the Federal Reserve Bank has turned the corner on quantitative easing (QE) and intends to gradually increase interest rates. Rate increases favor community and regional banks over major commercial or investment banks; the smaller retail banks typically derive a larger percentage of their earnings from net interest margin, the differential between the average interest rate a bank pays depositors and the average interest rate it charges for loans.

Policy Changes Favoring Small-Cap Bank Stocks

Another positive factor for small-cap bank stocks is some lessening by the federal government of the extremely restrictive regulations under the Dodd-Frank Act and other financial laws passed in the aftermath of the 2008 financial crisis. Owners of regional banks have made some headway in convincing legislators that their businesses are being unfairly hurt by extensive regulations that are more properly aimed at major financial firms, not local community banks. In 2015, the Federal Reserve relaxed some lending and acquisition regulations for regional banks. Small-cap banking firms are poised to eventually obtain a substantial advantage over major commercial banks in terms of being relatively less hampered by federal regulations and the costs of compliance.

First Trust NASDAQ ABA Community Bank ETF

Despite a wide variety of banking and financial sector ETFs available to investors, it isn't easy to find one specifically focused on small-cap banks. Even banking ETFs that include a number of small-cap firms, or whose index weighting methodology is tilted in favor of small-cap equities, still tend to have a portfolio dominated by relatively larger banks, such as SunTrust Banks Inc. (NYSE: STI), with its market capitalization value of nearly $20 billion.

However, the First Trust NASDAQ ABA Community Bank ETF (NASDAQ: QABA), launched by First Trust Advisors in 2009, is virtually a pure-play investment in small-cap bank stocks. This community bank ETF achieves its concentration on small-cap firms primarily through the makeup of its underlying benchmark index, the NASDAQ OMX ABA Community Bank Index. The index is made up of NASDAQ-listed bank and thrift stocks as determined by the American Bankers Association (ABA), but it purposely excludes the 50 largest U.S. banking firms, along with companies that have credit card or international specializations. Combined with a market cap weighting methodology that tilts the index in favor of small-cap firms, the end result is a portfolio with approximately 85% of its assets dedicated to small-cap and micro-cap bank stocks. Even with mid-cap stocks accounting for just under 20% of the portfolio, the weighted average market cap value of the ETF's holdings is just $2.4 billion, which is the lowest in the regional bank ETF category.

As of June 2016, this First Trust ETF had $157 million in assets under management (AUM). With an average bid-ask spread of 0.39%, its relatively low liquidity makes it unsuitable for frequent traders and only appropriate for investors with more long-range investment horizons.

Portfolio, Fees and Performance

The portfolio consists of approximately 150 bank stocks. The weighted average price-to-book (P/B) ratio of the fund's holdings is just 1.4, making this ETF appealing to value investors. That appeal is bolstered by the fact that value stocks overwhelmingly dominate the portfolio; 85% of the fund securities are classified as value stocks, and only 15% of the portfolio holdings are classified as growth or growth/value blend stocks.

The top three portfolio holdings are Signature Bank (NASDAQ: SBNY), TFS Financial Corporation (NASDAQ: TFSL) and East West Bancorp Inc. (NASDAQ: EWBC). The annual portfolio turnover ratio is a moderate 19%.

The expense ratio for the First Trust NASDAQ ABA Community Bank ETF is 0.6%, which is a bit above the financial category average of 0.45%, but still well below some other bank ETFs, with expense ratios as high as 0.95%. The fund's 12-month dividend yield is 1.36%. The five-year average annualized return, as of June 2016, was 10.26%, significantly outperforming the category average of 8.06%. This fund, along with most financial sector ETFs, was down year-to-date (YTD) in June 2016, but its 6.37% loss was a better performance than the category average YTD loss of 9.94%.

Morningstar rates the First Trust NASDAQ ABA Community Bank ETF, on a five-year basis, as above-average in both risk and return.