What mutual funds specialize in smaller banks? What about regional banks?

QUESTION: Are there any mutual funds that specialize in smaller community banks? What about regional banks?

-- Helen Meyer

ANSWER: Considering that the mutual-fund universe consists of more than 8,200 offerings, you can pretty much bet that for every corner of the investing world, there's at least one mutual fund that specializes in it. Small banks are no exception.

And these days, figuring out which funds are chock full of small-bank stocks isn't too hard. Using our SmartMoney Tool to screen for the top funds in the financial-services sector year-to-date, you'll come up with a tidy list. That's because, as you probably know, this group has been one of the few bright spots in the stock market this year. Indeed, while the average financial-services fund is currently up 6.0% in 2002, according to investment-research firm Morningstar, funds loaded up with smaller bank stocks are sporting returns in the mid- to high teens. (Cha-ching!)

So what's driving returns? Several factors, fund managers and analysts say. For starters, in an environment where large banks have suffered due to their exposure to the capital markets, small banks and thrifts (which focus mostly on consumer loans and mortgages, respectively) have looked especially attractive. "This particular downturn was so surprising because it never really hit Main Street," says Kenneth Mertz, manager of Emerald Banking & Finance (HSSAX). In other words, consumers have continued to buy homes, refinance their mortgages, take out new loans and seek the shelter of CDs and money-market accounts. Investors, meanwhile, have been drawn to the more straightforward accounting (in the post-Enron (ENRNQ) environment) and relatively cheap prices (on a price-to-book and price-to-earnings basis) of small banks compared with the larger banking stocks and the market as a whole, explains David Ellison, manager of the FBR Small Cap Financial fund (FBRSX).

Of course, just how well this group will perform going forward depends, in part, on the intensity of our economic recovery. If you think that we're looking at a dramatic and robust recovery (which, granted, is currently not a widely held belief), then now probably isn't the time to buy. That's because rapid interest-rate increases would most likely take a toll on these banks, says Scott Cooley, senior analyst at Morningstar. Also, if the economy once again begins to expand significantly, investors would most likely be lured to other, more growth-oriented stocks, which could cause stock prices in this group to deflate. On the flip side, a modest recovery could be good for these banks, says Mertz, since it would increase the demand for consumer and small-business loans. Ongoing consolidation in this sector also continues to be a plus.

Nevertheless, given the recent run-up, you could be a bit late to this party -- at least over the short term. Assuming, however, that you're a long-term investor (and not chasing returns), you may simply want to dollar-cost average into your fund of choice to help ensure that you aren't buying at a peak. What are some good funds? Our favorite in this sector is Ellison's fund (click here for a profile), thanks to his tenure in the business, the fund's impressive track record (its five-year annualized return is 18%, placing it in the top 1% of its peer group) and because the fund doesn't carry a load. Other small-cap financial funds that focus on the banking sector include Senbanc (SENBX), Diamond Hill Bank & Financial (BANCX) and Emerald Banking & Finance (listed above).

At the heftier end of this group of funds are ones that mostly hold regional banks (as opposed to the small community banks and thrifts). While all the funds listed above have median market caps below $500 million (which places them firmly in small-cap and, in some cases, even microcap domain), if you're looking for more regional bank-stock exposure, consider the John Hancock Regional Bank fund (FRBCX), which has a median market cap of $9.7 billion. You also could check out Fidelity Select Home Finance fund (FSVLX), which has a median market cap of $6.9 billion. Unfortunately, both of these funds carry loads.

One last caveat: With any of these funds, don't expect a smooth ride. Sure, this group has performed well over the past couple of years, but these funds can also have painful off years. That's why you shouldn't allocate more than 10% of your portfolio to the financial sector, says Cooley.