Regional Banks have all the characteristics of Schrödinger’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.
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. This leveraged ETF aims to provide three times the return of its benchmark index for a single day. However, it is not designed to offer three times the return for periods longer than a day. The fund primarily utilizes swaps to achieve its notional exposure, with holdings in regional banking companies such as New York Community Bancorp (NYCB), M&T Bank Corporation (MTB), and PacWest Bancorp (PACW).
With an expense ratio of 0.93%, DPST is reasonably priced considering its 3X leverage. It is important to note that due to inherent decay, this fund is more suitable for short-term trading rather than long-term investment strategies.
John Hancock Financial Opportunities Fund (BTO)
While not specifically marketed as a regional bank fund, BTO functions similarly to one. It employs the S&P Composite 1500 Banks Index as its benchmark and holds assets that support this focus. BTO has a slightly higher expense ratio, nearing 2%, but has historically exhibited strong performance.
Regional Banks as an Investment
The regional banking sector appears incredibly cheap when considering valuation metrics. Common holdings of both DPST and BTO, such as NYCB and MTB, exhibit low forward P/E ratios and attractive dividend yields. Furthermore, these banks appear cheap when assessed by the price to tangible book value metric.
However, it is essential to address the funding model of regional banks, which heavily relies on low-cost deposits. In light of the rates offered by money market funds, this funding model becomes less favorable. Analysts seem to be overlooking this crucial aspect, even though the valuation may already account for risks like held-to-maturity loans and potential recession losses.
Playing DPST and BTO
Given the potential funding pressures regional banks may face in the coming months, a prudent approach involves reduced leverage and reduced beta. One strategy could be selecting a preferred regional bank and employing covered calls to mitigate volatility. This approach provides a moderate return even in a flat price environment.
However, it is worth noting that both DPST and BTO do not align well with this strategy. DPST’s 3X leverage setting leads to inherent decay, negatively impacting investors. BTO, although employing less leverage, still trades at a premium to net asset value (NAV). A decline in the regional index could further reduce BTO’s NAV, resulting in significant price drops as the premium transitions to a discount. DPST is more suitable for short-term trading, while BTO performs better but still carries risks. Employing strategies that reduce volatility, such as covered calls, may offer better prospects.