DPST - DPST And BTO: Schrodinger's Regional Banks

2023-06-27 06:14:14 ET

Summary

• Regional Banks have all the characteristics of Schrodinger's Cat.
• They appear phenomenally cheap on current earnings.
• They are dead in the water when you price in a reasonable cost of funds.
• We look at two popular funds and tell you how you should play them.

Schrödinger's Cat. Who amongst us has not been fascinated with that brilliant thought experiment? The hypothetical cat may be considered simultaneously both alive and dead. As long as it is unobserved in a closed box, either outcome is equally probable. Now it may be a small leap but one cannot help but think of the regional banks in the same context. Many of them have been in this paradoxical state. As long as you don't look at their balance sheets, and as long as you don't look at what their funding costs will be, hey they are all alive and kicking. But if you have a peek at either of them, well that is a different story. We look at two popular funds to play this space and tell you which one we would use and why.

Direxion Daily Regional Banks Bull 3X Shares ETF ( DPST )

According to the fund website,

"DPST seeks daily investment results, before fees and expenses, of 300% of the performance of the S&P Regional Banks Select Industry Index. There is no guarantee the fund will meet its stated investment objective. This leveraged ETF seeks a return that is 300% of the return of its benchmark index for a single day . The fund should not be expected to provide three times the return of the benchmark’s cumulative return for periods greater than a day. "

Source: DPST

The fund owns the who's who of the regional banking sector. If you go through the daily holdings you will find familiar names like New York Community Bancorp ( NYCB ), M&T Bank Corporation ( MTB ) and PacWest Bancorp ( PACW ). But those holdings are a small percentage of the notional exposure. The bulk of the exposure comes via its swaps. You can see the latest swaps below and percentage of fund assets below. That my friends is how you reach your 300% notional exposure.

The fund comes with a 0.93% expense ratio, which seems reasonable for a 3X leveraged fund.

John Hancock Financial Opportunities Fund ( BTO )

This is the second star of the day. Unlike DPST this is a closed end fund. While the fund does not advertise itself as a regional bank fund, it does function like one. It uses S&P Composite 1500 Banks Index as its benchmark. Its holdings support that assumption as well.

Below we have shown BTO versus the SPDR S&P Regional Banking ETF ( KRE ). While the dance steps may not match exactly, there is definitely a very similar vibe.

The fund's expense ratio stands a bit high as it is nearing 2%.

Historically the fund has earned this through its outperformance but we are in different times today.

Regional Banks As An Investment

A key theme of how well these funds will perform will depend on how the regional banks do. Here the macro analysis of the sector comes down to two key thoughts. The first being that sector looks incredibly cheap on valuation. We use a couple of examples here from common holdings of these two funds. NYCB and MTB have a forward P/E ratio averaging around 8. The two also sport fantastic dividend yields.

On a more crucial valuation metric, price to tangible book value, again they ring in very cheap relative to their history.

Now you can run this across the sector and you can dig in through each of the two funds' holdings. You will find this general picture for every stock. On the three metrics you will get cheap, cheap and very cheap. So the value is there. Unfortunately there is a very big problem here. That problem is that the regional banking analysts are ignoring the elephant in the room. No, we are not talking about the "held to maturity" (also known as mark to fantasy to us) loans. We are not even talking about the potential losses in a recession, though that is a valid concern. We think the valuation actually discounts those two risks quite nicely. What we are talking about is the funding model. These regional banks have relied on extremely low cost deposits to fund their loan/asset books. That funding model looks bizarre today in light of what money market funds are paying.

We have also started seeing rapid flight from bank checking accounts (orange line) to money market funds (red line). Banks are stemming some of this via CDs (blue line), but they come incredibly expensive relative to the free checking funds.

Funnily no analyst is modeling this. MTB from our earlier example is expected to hold earnings flat over the next two years.

We love the bank and we actually gave it a rare buy rating last time we wrote on it. But no, those earnings are not going to come to fruition. Conservatively we think earnings decline 50% just from interest margin pressures and a shallow recession in most regional banks.

Playing DPST AND BTO

With regional banks likely to face incredible funding pressures over the next 12-24 months, our take is that playing is best done via reduced leverage and reduced beta. In other words, we would pick our favorite regional bank and then sell covered calls on it to further reduce the volatility. We showed an example below for MTB using current prices.

This method thus creates a moderate return in case of a flattish price environment. In the example above the returns would hold even if the price fell by $4.00 a share.

This is exactly the opposite with both these funds.

DPST uses a 3X leverage setting. That is bad even in cases of a sideways movement due to the large inherent decay in the fund assets. Generally you can expect downward movement of greater than 3X over short timeframes when the primary index declines slightly.

The fund is constantly "buying high" and "selling low" so this impacts you very negatively.

BTO has two issues here. The first is the same as with DPST, leverage. Now BTO uses far less leverage. Effective leverage is 21.34% of total assets.

We like this stated as a percentage of net assets but even that number is just 27%. As far as leveraged funds and CEFs go, this one does ok. But we still don't think regional banks should be played with any leverage and preferable should be played with beta diminishing tools like covered calls.

The second problem is that the fund still, trades at a premium to NAV.

So you could have your decline magnified by it moving to a 10% discount. If you envision the regional index declining by 20%, then BTO NAV could drop 25% and price could drop well north of 30% as the premium changes to a discount.

Verdict

While the urge to catch the regional bank falling knives is strong, one must use a healthy dose of caution. DPST is possibly the worst tool to play anything other than a short term bounce. It also gets the highest rating on our potential pain scale.

BTO is better and investors are likely enamored by the dividend yield. It does better than DPST and this price it is hard to hate it. It gets a 5 on our potential pain scale.

But we can generate far better covered call yields while reducing our volatility. That is the way we would go.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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