New ETF Taps Small-Bank Stocks

The misuse of leverage and complicated debt securities brought the financial-services industry to the brink last year. While the problem roiled big institutions like Bank of America ( BAC) and Citigroup ( C), community banks avoided the brunt of the crisis.

A new exchange traded fund aims to take advantage of the relative simplicity of small banks, which rely on deposits and local loans. The First Trust Nasdaq ABA Community Banks Index Fund ( QABA), introduced last week, says in its investor guide that these companies "tend to be more cautious than their larger counterparts, and take less risk when making lending decisions." These banks also avoided the financial instruments that took down companies like Lehman Brothers Holdings and Washington Mutual.

First Trust, the company running the fund, is betting that people will save more of their incomes and pick local banks over large institutions. Customers will feel safer doing business with a smaller bank.

While community banks are generally more conservative, I wouldn't rule out the possibility of future problems given the surprising depth of the financial crisis.

Still, this ETF is innovative because it offers a way to access a part of the market that's usually difficult to reach: small-cap financial stocks. That's a huge plus for do-it-yourself investors who want to diversify beyond the major indices while avoiding the risks of picking individual stocks.

This ETF is comprised of Nasdaq-listed banks with market caps of at least $200 million. The fund, which has 96 holdings, weeds out the 50 largest banks along with international banks and companies that specialize in credit cards.

Its top two holdings are People's United Financial ( PBCT) with an 8% weighting, and TFS Financial ( TFSL) with a 5% weighting.

The chart below compares these companies with the Financial Select Sector SPDR Fund ( XLF), a popular proxy for large-cap financial stocks. These companies have had an apocalyptic drop from their peak two years ago, while community banks have had a more typical bear-market decline.

Source: Yahoo! finance

These days, successful investors must actively manage not only the country, market cap and industry weightings of their portfolios, but also the subcategories of those groups.

ETFs have been helpful on this front. Funds with broad scopes allow you to build positions in international companies or large industries. Specialized ones, like the First Trust Community Banks ETF, allow you to adjust your portfolio's volatility and market-cap exposure.

I expect more specialized funds to hit the market, offering investors even more choices.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.