NEW YORK ( TheStreet ) -- Most exchange-traded funds that track the financial sector have rallied lately, but the gains have been particularly strong for ETFs that specialize in insurance and regional banks. This year SPDR S&P Regional Banking ( KRE) returned 28.0%, and SPDR S&P Insurance ( KIE) gained 28.5%, according to Morningstar.
In comparison, Vanguard Financials ( VFH), which holds a broad mix of financial stocks, gained 21.6%, and the S&P 500 returned 19.7%. The outlook for the hottest financial ETFs remains positive because regional banks and insurers tend to perform well when interest rates are climbing. Insurance companies take in premiums and invest the cash in portfolios of bonds. When yields increase, the income from bond portfolios also climbs. If we are entering an era of higher interest rates -- as most economists expect -- then it is likely that insurers will report stronger returns on equity in coming years. This year insurance companies have gotten an additional boost from rising premiums. The gains appear to signal the beginning of an upward cycle. The industry tends to go through premium cycles that last for several years. During some periods, insurers become more aggressive, slashing premiums to gain more market share. Eventually premiums become too skimpy. With profit margins unacceptably low, the industry begins raising premiums, and a new cycle starts. In recent years, premium cuts hurt profits. Now companies are raising premiums as the industry strives to fatten bottom lines -- and avoid destructive price cutting. The biggest insurance ETFs are SPDR S&P Insurance, with $354 million in assets, and iShares U.S. Insurance ( IAK), with $149 million. The two funds have delivered similar returns recently. During the past 12 months, the SPDR ETF returned 33.5%, while the iShares competitor returned 34.8%. When rates rise, banks can charge customers more for loans. That helps institutions of all sizes. But regional and community banks tend to receive a special lift from climbing rates.
The smaller banks tend to be simple operations that focus on making loans to individuals and small businesses. Besides making loans, money center banks have a variety of complex businesses -- such as investment banking and derivatives trading -- that don't necessarily improve when rates rise.