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How to Own Financials but Dodge LIBOR Rigging and New Scandals

Conflict, illegal acts and scandal have always been a part of the industry's landscape and always will be. When new laws are enacted, firms get to work right away to figure out how to work around them. Occasionally there is scandal along the lines of what is alleged with LIBOR. Once this scandal is resolved there will be something else that pops up. It is inevitable when young, smart, aggressive bankers see the potential for bigger pay checks.

It is likely that most of the banks will get away with what they have done by simply paying fines that they write down against their earnings. JPMorgan has recently paid $2 billion for its involvement with the Madoff scandal, $13 billion for toxic mortgages and $920 million for losses connected to Bruno Iksil, the London Whale. None of this prevented JPMorgan's stock from going up 26% so far in 2013.

Occasionally a large financial institution will fail -- recall Bear Stearns, HBOS and Wachovia -- although it is rare. It would intuitively seem that there must be a limit to the number of billion dollar checks that can be written, but for now these settlements don't seem to be having an impact.

Investors could reasonably become concerned that there is a limit to how many fines the bigger banks could pay without collapsing.

But there are other segments within the financial sector that generally avoid scandal and offer tremendous return potential.

Sticking with domestic banks, investors could consider the SPDR S&P Regional Banking ETF (KRE). It fared better during the financial crisis than did the Financial Select Sector SPDR (XLF), which owns most of the scandal ridden banks. KRE has a slightly higher yield than XLF and has better diversification too. KRE has done a good job avoiding scandal-ridden companies, although its holding Zion Bank (ZION) will have to write down $387 million in CDOs in order to comply with the Volcker Rule.

Where KRE is more of a mid-cap bank fund, investors can go smaller with the PowerShares S&P Small Cap Financial Portfolio (PSCF). Similar to KRE, PSCF avoids scandal, has a slightly higher yield and better diversification than XLF.

Or you might consider another area entirely. Think about the "pick and shovel companies," an analogy to the mining industry that describes publicly traded exchange stocks. There are four exchange stocks in the U.S. and many more foreign exchanges for investors to consider. All four domestic exchanges have outperformed XLF. For now there is no ETF that focuses solely on exchanges.

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