ETF Expert

Old TARP, New TARP, New Old TARP. On top of that… there's the "bad bank-good-bank" concept. Whatever the appropriate remedy, governments around the globe have been squarely focused on making sure that the biggest financial institutions survive. (We've all been calling it, "Too Big To Fail.")

Yet few market watchers ever talk about the smallest financial companies. Many of them abstained from making bad loans. Quite a few of them have exceptional balance sheets without any "toxic" assets.

Nevertheless, nobody trusts what a bank has to say about its financial health. (It wouldn't be prudent to trust them… at this juncture.)

For the sake of argument, though, let's assume that a silent majority of smaller banks aren't holding sub-prime toxic assets or credit card nightmares. A small bank can borrow from its peers at zero. It doesn't have to offer its depositors much more than 0% in a checking or savings account. And it's able to lend out at a rate… anywhere from 6% to 11%. Does it get more profitable than that?

Of course, this is completely predicated on qualified borrowers wanting to borrow. It's also predicated on bank willingness to take some risks through sound lending standards. So therein lies the "unknown."

Do any of the smaller banks want to step up to the plate? Or is it safer to make itsy bitsy profits on only sure-thing lending until the economy heals itself?

The problem for an ETF investor is that bank ETFs are, for the most part, market-cap weighted. That means you are primarily investing in the largest institutions with the streetTracks KBW Bank ETF (KBE), the iShares DJ Regional Bank Index (IAT) or the Financial Select SPDR (XLF). Worse yet, these indexes are down -35%, -31% and -28% in January alone!

Yet there may be some evidence that the theory about smaller banks holds merit. Consider Rydex Equal Weight Financials (RYF)… a fund that tracks an index of small, medium and large sized financial companies in equal proportion. It's down substantially less at -20% on the year. What's more, you can see the divergence taking shape — one that is likely attributable to smaller company representation in banks, insurance and diversified finance.

By no means am I suggesting that RYF or any exchange-traded common stock fund from the financial segment is flashing a green light. On the contrary. Traders might look to enter and exit, but I don't believe investors need any additional exposure to large financial companies than they already may have with broader market ETFs like the S&P 500 SPDR Trust (SPY).

What I am suggesting, however, is the possibility of seeking out small banks for a speculative investment for the next 3 years. And doing some thorough research.

For example, Hudson City Bancorp (HCBK) never lowered its underwriting standards to win business. They only lent to customers with solid credit via extremely conservative, "old school" practices.

The problem? HCBK is still taking a beating due to the pressures that New York itself is facing. A recession takes its toll on just about everybody. At the same time, you can see that it has outperformed the S&P 500 over the last year, and its prospects coming out of recession could be strong.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.