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You Don’t Have to Pick a Winner in Bank Stocks

Bank sign on traditional europe building facade
Image source: Getty Images

Written by Tony Dong at The Motley Fool Canada

Canadian bank stocks have long been a mainstay in many investor portfolios. Institutions like Royal Bank of Canada, Toronto-Dominion Bank, Canadian Imperial Bank of Commerce, Bank of Nova Scotia, and Bank of Montreal —often referred to as the “Big Five”—have historically offered reliable returns and a sense of solidity.

However, recent headwinds suggest that even these financial giants aren’t immune to challenges. The third-quarter earnings reports of Canada’s leading banks paint a complex picture. While some recorded higher profits year over year, others faced flat earnings growth, increasing provisions for credit losses, and non-interest expenses.

Such a turbulent backdrop naturally leads to investor anxiety, prompting many to agonize over which bank stocks to hold and which to jettison from their portfolios. But is this stock-picking approach the best way forward? I would argue against this strategy, and here’s why.

It’s all about correlations

At first glance, it might seem tempting to think of the Big Five Canadian banks as a cohesive bloc, moving in lockstep through economic cycles. However, that’s far from the reality. If you look at historical backtests, you’ll find that these banks have demonstrated varying degrees of returns, volatility, drawdowns, and even risk-adjusted returns.

Given these differences, you might be tempted to try to pick the “winner” among them, speculating on which bank will outperform the others over the next decade. But let’s be clear: attempting to forecast which of these banking behemoths will pull ahead is a fool’s gambit. Market conditions change, management strategies evolve, and a host of unforeseeable events can impact performance.

Consider this: the Big Five aren’t perfectly correlated with each other. That means that while they might all be influenced by similar macroeconomic factors like interest rates or inflation, each has its own set of circumstances that determine its performance—be it their exposure to different markets, loan portfolios, or even the efficiency of their operations.

Since these banks are not perfectly correlated, holding a basket of all five can offer diversification benefits. When one bank’s stock is down, another might be up or stable, effectively smoothing out the volatility in your portfolio.

This approach not only offers the potential for better risk-adjusted returns but also gives you exposure to the collective strengths of Canada’s financial sector, without making you overly dependent on the fortunes of a single institution.

How I would invest instead

Personally, I’d rather buy a bank exchange-traded fund (ETF) like BMO Equal Weight Banks Index ETF (TSX:ZEB) instead. This ETF holds all five of the big bank stocks, plus National Bank of Canada, in equal weights.

Essentially, it’s a ready-made portfolio of Canada’s banking sector, all contained in one easily traded ticker. The ETF re-balances itself periodically, so you don’t have to trade and manage the underlying holdings.

Best of all, you get all the dividends of the underlying bank stocks, which currently amounts to a 5.06% annualized yield as of September 15. However, unlike bank stocks, ZEB pays monthly dividends, which makes it great for income.

The post You Don’t Have to Pick a Winner in Bank Stocks appeared first on The Motley Fool Canada.

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Fool contributor Tony Dong has no position in any of the stocks mentioned. The Motley Fool recommends Bank Of Nova Scotia. The Motley Fool has a disclosure policy.