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February 26, 2024 | During a discussion last week on Behind the Markets, Jeremy Schwartz of Wisdom Tree asked how we feel about the banking industry. Our reply was that we would generally stay short most banks, but that does not mean that every bank stock is falling in value. Indeed, that is precisely the key point that investors should remember. Not all banks or companies are the same and not all follow the herd.
Years back at Institutional Risk Analytics, our pal Dennis Santiago in LA liked to say that the banking industry is a coral reef. The industry supports many different types of business models, large and small.
To help investors and other interested parties parse the difference between one bank and another, we published the WGA Bank Indices over the weekend. Big H/T to our friends at Thematic for getting it done. It's been years since we actually had to wait for a computer to finish a job. Indices are big.
Unlike traditional price-weighted indices which are biased toward larger stocks, the WGA Bank Indices employ a quantitative and qualitative scoring methodology. The scores for each bank are then arrayed using a pure constituent weighting system. This ensures that the highest scoring banks have the greatest impact on the Indices regardless of size.
Most Wall Street indices tend to buy “representative” baskets of stocks. These baskets inevitably include stocks based upon size rather than quality. Compare the 24 components of the Invesco KBW Bank ETF (KBWB) with the WGA Top 25 Bank Index (WBXXVPSW). Then look at the divergence in terms of performance. The banks in the WBXXVPSW self-select based on market and operational factors and the results speak for themselves.
WGA Bank Top 25 Index (WBXXVPSW)
The difference between KBWB and WBXXVPSW is that with the latter we don’t include banks in the bottom half of the industry distribution when measured against classical market and financial tests. No sad doggies like Citigroup (C) or Bank of America (BAC). Indeed, is it not remarkable that virtually all of the exchange traded funds and passive strategies focused on financials make no attempt to differentiate among banks based upon market or financial performance?
If we look at the WGA Bank Top 25 Bank Index, the difference between the Wall Street view and what investors actually want to see is striking. If you ask your friendly investment bank to show you the top ten US banks, they’ll probably serve up a list based upon total assets or maybe market capitalization. But don’t ask any of the conflicted investment banks and fund sponsors to make critical judgements about banks or companies when it comes to returns to investors.
Michael Green, Chief Strategist at Simplify Asset Management, said famously: "If you think about it, passive investing operates on the simplest set of instructions possible. If I give you money then buy. If I ask for money then sell." But the way that Wall Street often interprets these simple instructions is to buy everything without distinguishing between superior and inferior stocks.
“I view the markets as fundamentally broken,” said manager David Einhorn on Barry Ritholtz's Masters in Business podcast via Bloomberg earlier this year. "Passive investors have no opinion about value. They're going to assume everybody else has done the work.”
We believe that somebody needs to actually do the work on picking good banks from the bad, especially when the consumers are retail investors. Fortunately, the banks actually vote for themselves every day based upon classical measures of righteousness defined by prudential regulators and the markets over the past century.
Is Wall Street so conflicted that they cannot select between banks that are superior performers and those that are not? Yup. For those of us who work as financial professionals and have a duty of care and also a duty to determine suitability, just how do we include chronically poor performers with weak management and/or poor business models in an index used by retail investors? Help us here.
Let’s compare the WGA Top 25 Banks (WBXXVPSW) on the left with the 24 constituents of KBWB. Note that there are only three stocks in common between the two groups. Also note the poor rankings of many of the members of KBWB vs the higher ranking banks in WBXXVPSW. Night and day. Why should any retail ETF include bank stocks that are issued by institutions which are not even peer performers?
Source: Bloomberg, CapIQ, FFIEC
We must stipulate that we did forget to add Zion's Bancorp (ZION) to the list, but the omission was not intentional and will be fixed at the end of Q1 2024. Like Bank OZK (OZK), ZION is a unitary bank issuer and has no parent holding company. We also excluded Bank of NewYork Mellon (BNY) and State Street (STT) because these entities are atypical banks that provide commodity clearing and custodial services.
Obviously one reason to create an index is to use it for an Exchange Traded Fund (ETF). We have been exploring the world of passive investing over the past year and these inquiries impelled us to develop the WGA Bank Indices. Before you do the ETF, you must define the strategy via an index. More, during our investigations we discovered that there are few passive strategies focused on mortgage finance and fintech, and for good reason. We'll be addressing all of these areas in a future comment.
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