2024-01-09 12:31:49 ET
Summary
- iShares US Regional Banks ETF, which tracks the Dow Jones U.S. Select Regional Banks Index, has underperformed the broader market over the past year.
- We touch upon some of the underlying conditions afflicting regional banks.
- We measure IAT's qualities versus its largest peer - KRE.
- We close with some thoughts on the technicals.
ETF Snapshot and Recent Performance
Investors looking for targeted access to US regional banks may consider looking at the iShares US Regional Banks ETF (IAT). IAT tracks the Dow Jones U.S. Select Regional Banks Index, which in turn is a subset of Dow Jones U.S. Bank Index.
Banks that make up the former are selected on the basis on how much their average total assets account for, relative to the total assets held by all banks as determined by S&P Dow Jones Indices. This is determined on a 3-year average basis, and as of March 2023, each individual bank which comprises IAT's tracking index, owned assets that accounted for less than 5% of the assets held by all other banks.
Over the past year, IAT's regional banking portfolio has proven to be a disappointment of sorts, delivering returns of -11.53%, even as the broader markets fared a lot better churning out positive returns of 22%.
Nonetheless, if you're wondering about the prospect of a comeback and are intrigued by the history and the characteristics of the product, here are a few important things to consider.
Industry Commentary
The regional banking crisis in the first half of 2023 no doubt dented investor sentiment towards this sector, and it is still questionable if the underlying conditions are healthy enough to warrant a return of buoyancy.
One of the dominant corollaries of the crisis was a shift in deposits from these regional banks to the larger and more diversified players in the industry, and that trend still persists, although it isn't as fervent as it was back then.
To stay more competitive, the regionals will need to continue to offer more competitive rates of interest, even if there is a broad pivot in the interest rate trajectory in 2024. The regionals also lack ample diversification in their funding sources with a worrying predilection towards inimical interest-bearing deposits as opposed to non-interest-bearing deposits.
The image below gives you a sense of how dominant the former is in the deposit mix of these regionals, accounting for around 55-90% of the total mix.
Data from Nomis Solutions (a software provider for the banking industry) also shows that deposit betas for regional and community banks stood at a hefty level of low-60% range, versus only 15-19% for the largest US banks. Most traditional financial businesses have already been facing widespread pressures on their NIM (net interest margins) for the last three quarters, but for regional banks, things have been dialed up because of these funding pressures.
Then compared to previous cycles, asset quality issues are yet to rear their ugly head in a meaningful way, but do consider that delinquency rates across the system have started trending up sequentially over the last four quarters, and this will almost likely get worse given the rumbling issues with commercial real estate. As things stand, charge-off rates are still quite subdued at only 0.03%, but as more of these loans potentially go sour, the regionals will be forced to set aside more funds towards loan loss provisions, thus dampening the flow through to the bottom line.
Then conversely, a lot of these regionals are also carrying substantial unrealized losses on their AFS (Available For sale) and HTM (Held To Maturity) portfolios (for the entire industry it was estimated to be around $684bn as of Q3-23; source: FDIC), but with the Fed poised to cut rates this year, those portfolios could look a lot better.
IAT vs KRE
Other than IAT, investors mainly gravitate to the SPDR S&P Regional Banking ETF ( KRE ), which came to the bourses around the same time as IAT (in 2006), but has yet managed to accumulate a far larger AUM figure of $4.02bn (IAT's AUM is less than a fifth of KRE's figure). The relative popularity is also reiterated by the average daily dollar volume figures where KRE's figure of $849m is almost 60x of IRA.
Investors likely prefer KRE over IRA firstly because it is cheaper, (the expense ratio differential is 0.05%). Secondly, KRE offers a wider reach, covering 141 stocks (as opposed to only 39 stocks for IAT) and it does not come across as overly top-heavy (KRE's top-10 accounts for 39% of the portfolio) unlike IAT (68%).
Perhaps it also helps that KRE not only has a much superior return track record, it has also done relatively well in managing its risk and delivering superior risk-adjusted returns. Note that since both these ETFs came to the bourses, KRE's return profile has been a whopping 1.85x that of IAT's figure.
It isn't just the absolute returns, even if one considers the respective standard deviation of these two products, and then juxtaposes the excess returns (over the risk-free rate) delivered, note that KRE comes out on top, both over the long-term, or across the most recent three years.
Despite the unsavory track record, there are still a few factors that work well for IAT. Firstly note that IAT is more of a large-cap play (average market-cap of $21bn with a dominating large-cap share of 41% and no exposure to micro-caps) and this comes through by way of a lower risk profile.
The larger regionals are also believed to rely less on spread income and have a useful non-interest income ratio (vs total revenue) of over 30%. For instance, the large regional-US Bancorp which is IAT's top holding generates 40% of its revenue from stable fee-based activities.
Even from an income angle, IAT offers an edge; over the last three years it has grown its dividends at a faster pace than KRE's and this also puts its yield (which is better than KRE's) in a much better spot relative to its 4-year average.
Finally, also consider that IAT is the more stable portfolio of the two, with a low turnover ratio of just 7% whereas KRE is susceptible to a lot of churn where six out of every 10 stocks typically get rotated.
Closing Thoughts - Technical Considerations
The chart below highlights how regional banks are currently one of the most oversold components of the total stock market, and thus offer the promise of decent mean-reversion momentum.
Switching focus to IAT's long-term chart, we can see that since 2010 this product has experienced significant range expansion, captured within the two diverging black lines. From the start of 2022 until May 2023, we saw some pretty strong weakness, but since then, IAT appears to have taken support near the lower black line, and recently we've also seen a breakout from the red trendline, which bodes well for momentum players.
For further details see:
IAT ETF: Some Good, Some Bad