This week, financial stocks of all types are sliding on fears of more failures in the banking industry. But shares in major lenders remain dramatically improved from last year’s horrid returns.

Consider that Morgan Stanley, after losing nearly 68% in 2008, has returned more than 70% so far this year. Meanwhile, Goldman Sachs has risen some 90%-plus. And even laggard Citigroup, down more than 30%, staged a giant rally in August.

But while the bulge-bracket banks have boomed, local and regional banks have been depressed by a spate of bankruptcies of small financial institutions that has so far led to 106 bank closures in the U.S. Market watchers expect still more to come: Meredith Whitney, a prominent analyst, recently pointed out that the number could be nearer 200 once the Fed’s cleansing of the financial system has fully taken effect.

Big Bank, Small Bank Polarities

The polarization between the performance of large and small financial institutions has been felt acutely in the ETF arena, where many investors and advisers have used the products to hedge against long stock positions.

For example, while the SPDR KBW Regional Banking (NYSEArca: KRE), an ETF which tracks local banks, has dropped more than 26% year-to-date, in the same time frame the Financial Select Sector SPDR (NYSE Arca: XLF), which is invested in larger firms, is up by double-digits.

Broadly, asset managers have been using KRE to hedge their long positions in larger banks such as Citigroup. So far this year, they’ve been making money on both trades. Even in the case of better-performing regional bank ETFs, the buy-big, sell-small hedge has paid-off.

Regional Bank HOLDRs (NYSEArca: RKH) and SPDR KBW Bank (NYSEArca: KBE), two local bank ETFs, have risen only marginally in 2009.

With around 5% of banks and thrifts on regulators' watch lists, according to the latest Federal Deposit Insurance Corporation and Office of Thrift Supervision data, for now not many see much upside potential in investing in local banks.

Still, with so many financial ETFs available now, there may be some hidden gems lying among the rubble. Understanding the ETFs components is key.

Is Diversified Best?

Ironically, given today’s historically high volatility of the sector, part of the problem for financial ETFs is not only in their chosen areas of focus, but in their design as diversified products. Those that are least diversified have been performing more consistently than their more conservative counterparts.

KRE is the ultimate in diversified single-sector ETFs: just 27% of the fund’s capitalization is invested in its top 10 holdings. Compared with other financial ETFs, that’s pretty miniscule: First Trust Nasdaq ABA Community Bank Index Fund (NASDAQ: QABA), another small and regional bank ETF, concentrates 36% of its capital among its top ten positions. RKH and KBE are pretty nearly entirely invested in just ten banks, with more than 80% of their net asset values (NAVs) linked to their top ten holdings.

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