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

The passive strategy employed by ETFs, however, can not be counted on to make last-minute judgment calls, especially when a sector is facing a major downturn. Last summer, Ellison began to grow increasingly troubled by news emerging from the financial sector and decided to bulk up cash holdings in funds like FBRSX to stem the impending doom.

"Everything kept getting worse and worse," Ellison noted in a June 20 interview in The Wall Street Journal interview. He said "the stocks were being sucked into a negative vortex."

Ellison's decision-making saved his investors the drop experienced by IAT. For the one-year period ending June 19, IAT dropped 34.26% while FBRSX actually rose 1.81%.

Ellison believes that the time has come, however, to begin accumulating bank shares, if just gradually. Ellison's cash position, which was trimmed to just 10% during the worst of the banking downturn, is back up to 60% as he looks for opportunities in uncomplicated banks that have cut dividends and focused on income. While investors have to pay a higher price for Ellison's strategy, the cost is worth the comfort in an uncertain climate.

FBRSX's Top 10 Holdings (as of March 31) include Brookline Bancorp ( BRKL), Independent Bank Corp. ( INDB), BOK Financial ( BOKF), Webster Financial ( WBS), Redwood Trust ( RWT), Hingham Institution for Savings ( HIFS), Bank Mutual ( BKMU), WSFS Financial ( WSFS), Comerica ( CMA), and Astoria Financial ( AF).

IAT's Top 10 Holdings (as of June 18) include U.S. Bancorp ( USB), PNC Financial Services ( PNC), BB&T ( BBT), Northern Trust ( NTRS), SunTrust ( STI), Hudson City Bancorp ( HCBK), Regions Financial ( RF), Fifth Third Bancorp ( FITB), M&T Bank. ( MTB) and New York Community Bancorp ( NYB).
At the time of publication, Dion had no positions in the stocks mentioned.

Don Dion is the publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

Dion is also president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.