Regional Banks: ETF or a Mutual Fund?

As the beat-up banking sector regains its footing, investors are using funds like FBR Small Cap Financial(FBRSX Quote) and iShares Dow Jones U.S. Regional Banks(IAT Quote) to get back in action.

Strong regional banks have rallied in 2009, after being dragged down by their peers in a meltdown rooted in the broader financial industry.

FBRSX has risen 11.83% for the three months ending June 19, while IAT has rallied 16.78%.

While the transparency and low-cost structure of ETFs continue to attract investors in droves, the mutual fund methodology may work better when it comes to banks.

Picking individual banking stocks for your portfolio is perhaps more dangerous now than ever. Diversified funds serve as a good method to give your portfolio some exposure to the recovering industry without making your investments vulnerable to a particular bank.

Both IAT and FBRSX track smaller banks that have generally held up better amid the economic downturn. Because of its methodology, however, IAT holds more "super regional" banks than David Ellison's FBRSX, exposing investors to bigger banks generally avoided by its mutual fund peer.

For many investors it will come down to fees, and IAT's 0.48% expense ratio is certainly lighter than Ellison's 2.10%. But with the banking sector proving so uncertain, is the passive strategy a safe course?

IAT uses a capitalization-weighted index to track regional banks, a strategy that often results in a high concentration of assets in top holdings. U.S. Bancorp currently makes up more than 19% of IAT, a concentration that overexposes investors to the gyrations of one stock. IAT currently stakes nearly 64% of its portfolio on its top 10 holdings while Ellison's top 10 make up just 17%.