Don Dion

As the beat-up banking sector regains its footing, investors are using funds like FBR Small Cap Financial(FBRSX Quote) and iShares Dow Jones U.S. Regional Banks(IAT Quote) to get back in action.

Strong regional banks have rallied in 2009, after being dragged down by their peers in a meltdown rooted in the broader financial industry.

FBRSX has risen 11.83% for the three months ending June 19, while IAT has rallied 16.78%.

While the transparency and low-cost structure of ETFs continue to attract investors in droves, the mutual fund methodology may work better when it comes to banks.

Picking individual banking stocks for your portfolio is perhaps more dangerous now than ever. Diversified funds serve as a good method to give your portfolio some exposure to the recovering industry without making your investments vulnerable to a particular bank.

Both IAT and FBRSX track smaller banks that have generally held up better amid the economic downturn. Because of its methodology, however, IAT holds more “super regional” banks than David Ellison’s FBRSX, exposing investors to bigger banks generally avoided by its mutual fund peer.

For many investors it will come down to fees, and IAT’s 0.48% expense ratio is certainly lighter than Ellison’s 2.10%. But with the banking sector proving so uncertain, is the passive strategy a safe course?

IAT uses a capitalization-weighted index to track regional banks, a strategy that often results in a high concentration of assets in top holdings. U.S. Bancorp currently makes up more than 19% of IAT, a concentration that overexposes investors to the gyrations of one stock. IAT currently stakes nearly 64% of its portfolio on its top 10 holdings while Ellison’s top 10 make up just 17%.

The passive strategy employed by ETFs, however, can not be counted on to make last-minute judgment calls, especially when a sector is facing a major downturn. Last summer, Ellison began to grow increasingly troubled by news emerging from the financial sector and decided to bulk up cash holdings in funds like FBRSX to stem the impending doom.

“Everything kept getting worse and worse,” Ellison noted in a June 20 interview in The Wall Street Journal interview. He said “the stocks were being sucked into a negative vortex.”

Ellison’s decision-making saved his investors the drop experienced by IAT. For the one-year period ending June 19, IAT dropped 34.26% while FBRSX actually rose 1.81%.

Ellison believes that the time has come, however, to begin accumulating bank shares, if just gradually. Ellison’s cash position, which was trimmed to just 10% during the worst of the banking downturn, is back up to 60% as he looks for opportunities in uncomplicated banks that have cut dividends and focused on income. While investors have to pay a higher price for Ellison’s strategy, the cost is worth the comfort in an uncertain climate.

FBRSX’s Top 10 Holdings (as of March 31) include Brookline Bancorp(BRKL Quote), Independent Bank Corp.(INDB Quote), BOK Financial(BOKF Quote), Webster Financial(WBS Quote), Redwood Trust(RWT Quote), Hingham Institution for Savings(HIFS Quote), Bank Mutual(BKMU Quote), WSFS Financial(WSFS Quote), Comerica(CMA Quote), and Astoria Financial(AF Quote).

IAT’s Top 10 Holdings (as of June 18) include U.S. Bancorp(USB Quote), PNC Financial Services(PNC Quote), BB&T(BBT Quote), Northern Trust(NTRS Quote), SunTrust(STI Quote), Hudson City Bancorp(HCBK Quote), Regions Financial (RF Quote), Fifth Third Bancorp(FITB Quote), M&T Bank.(MTB Quote) and New York Community Bancorp(NYB Quote).