Smart investors are rushing back into the banks

Regulators are pulling back and the smart money is piling in – it’s time to buy again, says David C Stevenson. Here, he looks at the best funds to buy now.

Our scandal-prone high-street banks are quite possibly the most hated companies on the planet. But like 'em or loathe 'em, the sad fact is that they're still going to account for the vast bulk of banking business being done on a high street near you for the foreseeable future.

I may like the smaller, insurgent banks such as Handelsbanken and Metro Bank, but a) you can't invest in them and b) they will still be small players aimed at niche markets.

Equally, while both Co-operative Bank and Virgin are trying to mount convincing attacks on the high street, evidence suggests that the big banks will probably win in the end, if only because it's in the interests of central banks and the regulators to have someone big enough to bash: the mega-banks also manage the money-transmission mechanisms that keep the economy going.

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In fact, you could argue that we're at the start of a long phase of regulatory creep back'. Investors had run scared from retail banking stocks in recent years, worried that underlying account profitability would be hammered by twin attacks.

There was the threat at the global level from the Basel III capital funding requirements. Then there were local regulatory pressures to ring-fence casino' investment banks (usually more profitable) from stodgy, utility-like retail banks.

Further nails in the banking coffin consisted of legislative attacks on what banks could charge for money transfers (a big blow in America) and moves to ease bank-account transfers (still on the agenda here in Britain).

But this regulatory creep' into how a bank works at the micro level has started to look a great deal less scary in recent months. Global regulators are quietly retreating on some parts of Basel III, recognising that much higher capital reserve levels result in lower lending. Equally, banking lobbyists have pushed back hard on attacks on the operating model, slowing down reforms to the clearing systems.

These lobbyists, such as the British Bankers' Association (BBA), have also started reminding regulators that a growing number of individual current accounts actually lose money for the banks. So any push to cut charges will simply result in more people going unbanked and left to the mercy of outfits such as short-term lender Wonga.

Banking's funny old world

As regulators quietly pull back on micro-intervention, a new vision of banking is emerging. Retail banks look more like dull utilities, with lower but more predictable margins, feeding through into more conservative balance sheets.

Dividend payments have slowly restarted. God forbid, the sector might even undergo merger and acquisition activity (again) as the weaker outfits fall prey to more conservative players with big balance sheets.

Maybe we'll end up with a smaller number of even bigger banks, with a longer tail of small institutions snapping away lower down the food chain. Not quite what we all hoped would happen but markets are funny old places.

The durability of this regulator-sanctioned new normal' hasn't gone unnoticed by institutional investors, who have quietly switched equity exposures back into financial stocks, even in the troubled eurozone.

Most of the major banking indices are up by at least 20% in the last year, if not a lot more. That flow of money isn't likely to stop any time soon, especially if more and more American banks restart dividend programmes.

The smart money has already pushed into the core US big banks, with indices tracking the likes of JP Morgan and Wells Fargo up substantially over the year. Some of that money is now filtering down to the smaller regional banks, which have extensive consumer and mortgage servicing operations.

Hedge-fund money is also moving into the more troubled casino' banking operations legendary hedge-fund manager Dan Loeb of Third Point has switched his attention from bumper profits on Greek state bonds to Morgan Stanley, where he thinks there could be a huge amount of residual value.

Even our stodgy banking sector has had a perky 12 months, up 21% over the last year, with investors quietly moving back into the likes of Standard Chartered after its travails with the regulators.

The eurozone has also mounted a convincing rally, with many institutional investors targeting what they see as quality operators in national markets, such as BNP Paribas in France.

I'd wager that this push back into financials will continue if equity markets stay optimistic (a big if', of course as Italy's woes show, the potential for upset is never far away). That upsurge may even extend out to the even more unloved insurance sector, where valuations are still at all-time lows.

How to profit from the rally

The mainstream way to play this shift is through an actively managed unit trust. There are two very obvious choices, Jupiter Financial Opportunities and Henderson Global Financials.

If you prefer exchange-traded funds (ETFs), there's a lower-cost alternative from Deutsche db X: the Stoxx Europe 600 Banks ETF (LSE: XS7R), which tracks the Stoxx 600 European index of banking stocks. It has a total expense ratio of 0.30%. Major holdings include HSBC, Santander Group and BNP Paribas.

It's worth noting that Deutsche db X provides a short tracker (LSE: XS7S) for the index too (ie, the value of this tracker will go up in value as these banks go down in value).

More cautious investors might be tempted to look to America, where the big banks seem to be in much better shape at both the balance-sheet level (with dividends restarting) and the regulatory level (much of the nastiness has already happened).

The two obvious choices are both from iShares' US operation: the US Financial Services ETF (NYSE: IYG), which includes insurance companies, and the US Regional Banks ETF (NYSE: IAT).

On the Morgan Stanley idea, Dan Loeb's US fund can be accessed via a UK-listed closed-end fund called Third Point Offshore (LSE: TPOU) I think Leob is onto something with Morgan Stanley, but that position is only one of many in the fund (which I own shares in).

Last but by no means least, adventurous types who think that the global banking sector is in even better shape than we dare imagine could look at some very risky, highly contrarian' ideas.

The Chinese banks either cesspits of bad debts or very cheap, depending on your view could race ahead if the local economy picks up steam again. That could produce a strong momentum push, in which case Deutsche db X-tracker CSI 300 Financials (HK: 2844; Germany: XCSF) could be the place to be.

In Europe, listed structured product provider Socit Gnrale has a tracker on the STOXX 600 index of banks that gives up to three times the returns on that index (on the upside) through to 2015. The tickers are LC09 or LC10.

But beware on these two the painful outcome of the Italian elections has shown how volatile markets can suddenly become, and you may be able to buy either product cheaper later in the year, especially if there are any further panics.