The Regional Bank HOLDR (RKH) is an exchange-traded fund that owns stocks in companies that offer banking related services but are not considered to be national money center (New York) banks.

Because HOLDRS never sell securities once they are placed in the portfolio trust (even if the underlying companies change their business lines, or because of mergers and acquisitions), all HOLDRS are subject to shifting portfolio representation. For example, RKH used to hold Bank One in its portfolio. Although Bank One is very large and is a major national credit card issuer, the firm did most of its banking business in the Midwest. However, since the merger with JP Morgan Chase (JPM), the fund now has a greater than 12.6% concentration in that national money center bank. Another example: Bank of America (BAC) continues to buy up other large regional banks and can no longer be considered a west coast institution. BAC comprises about 9.2% of RKH.

RKH holds several banks with businesses in Florida as well. The fund has strong representation in companies that do business in the east, southeast and central/mid-west. There is less in the southwest and the west, so there is not a particularly balanced level of exposure to different parts of the country.

There are other oddities in the fund's portfolio. For example, the fund has a small holding in Piper Jaffray (PJC, 0.2%), as it was spun off from US Bancorp (USB, 12.3%). Meanwhile, another fund component, PNC Financial Services (PNC, 3.6%), is extremely diversified with large parts of its business in brokerage and asset management, in addition to traditional and mortgage banking.

Historically, financial services firms have been considered a poor bet during periods of rising interest rates. This was due to the fact that many banks had a hard time matching their asset flows (fixed interest rate loans) with their liabilities (often floating deposit rates). However, this has now changed. Many banks specialize in adjustable rate loan products, so banks are now less susceptible to rising rates. These adjustable products may even be priced off a spread to the banks' funding costs.

This will not prevent these firms' prices from falling if the economy slows while rates rise, which I consider a possibility during the next few quarters. As the yield curve flattens, adjustable rate mortgages will become less attractive, forcing banks to issue more fixed-rate loans. Problems at Fannie Mae (FNM) might also make it more expensive for banks to sell their mortgage loans. Many banks remove their asset and liability cash flow risk by selling their loans. However, a slower economy and higher interest rates will mean less loan demand (and therefore earnings), be it commercial or residential.

The new face of banking means that these firms now have greater flexibility than they did before deregulation. While they may have greater earnings volatility due to ownership of brokerage firms, that is at least partially offset by their greater product diversification. Since banks also often pay better-than-average dividends, these stocks, though not likely to completely avoid losses in a market downturn, should make a decent defensive choice.

A quick reminder about HOLDRS...
HOLDRS, which are managed by brokerage giant Merrill Lynch, are a bit different from traditional ETFs in the way they trade and in their expense ratios. For example, you cannot buy or sell fewer than 100 shares of a HOLDR in any transaction. Instead, these unique instruments can only be traded in 100-share round lots. In addition, unlike most other types of funds, which track broad-based indices that contain hundreds (or some cases even thousands) of stocks, most HOLDRS consist of just a handful of stocks and are designed to track a particular industry group.

Because they only track a few companies, HOLDRS are very inexpensive to manage. However, because they aren't highly diversified, they also tend to be much more volatile than your average ETFs. HOLDRS also directly pass through any distributions the underlying securities make. This may lead to tax consequences different than what you would expect from an ordinary ETF. Note that because the fund's components never change, corporate restructurings and changes could ultimately result in a HOLDR no longer being representative of its original sector design. After purchasing a HOLDR, you will receive annual and quarterly reports from each individual company held by the fund.

HOW TO MAKE MONEY IN RKH THIS YEAR
RKH continues to struggle higher. As I noted above, the expected increase in interest rates should not be as much of a problem for banks as past increases have, because most banks are now selling a large quantity of adjustable rate mortgages. Additionally, banks tend to sell their mortgages, and as such, do not have the same risk in trying to match their assets (loans) and liabilities (deposits). However, if the economy slows and the Fed continues to increase interest rates, then the spread that the banks make will narrow as the yield curve flattens or inverts.

Look for RKH to grind higher towards channel resistance, though a move above $140 is difficult to countenance. Ultimately, RKH will give up the ghost, and a retest into the low-$130s to low-$120s is possible, along with an expected sharp drop in the overall U.S. stock market. That said, the long-term pattern remains bullish and I would not be surprised to see RKH rally to $155-$165 within the next 12-18 months.

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