The Risks of Banking on Bank Stocks

This sure seems like a great time to bet on the financial sector. Seven years after the credit crisis, banks are healthy again, says Morningstar analyst Dan Werner. In fact, regulators are finally letting them boost dividends and share buybacks. While S&P 500 profits are flat this year, financial earnings are forecast to grow 11%. And in theory those profits might be even stronger once interest rates rise, since borrowers will no longer be able to refinance into ever-cheaper loans.

Yet despite all of that, there's trepidation—and rightly so—when it comes to this sector, which let investors down so badly during the global financial crisis.

For starters, investors fear regulations, says BlackRock's global chief investment strategist Russ Koesterich. Banks are still paying for the sins of the Great Recession, through fines, settlements, and increased oversight, which lead to higher costs. J.P. Morgan Chase alone incurred $487 million in legal fees last quarter.

Moreover, as yields rise, there are no assurances bank profits will benefit. The Federal Reserve controls only short-term rates. "One risk is the Fed raises short rates, yet there's no sign of inflation," which affects long rates, says Mark Luschini, strategist for Janney Montgomery Scott. If that happens, demand for longer-term bonds could rise, pushing prices higher but yields lower. That would narrow the gap between what short- and long-term bonds pay, crimping profit margins, as banks borrow short term to lend long.

Until the Fed hikes and you see how long-term rates react, "financial stocks are basically in a holding pattern," says S&P Capital IQ's Erik Oja. So it's critical to hold the right types of financials in this unpredictable environment. These steps will help you find them:

Go with a proven winner. Follow the Hippocratic oath of investing: "Avoid companies with a proven record of screwing up," says Chris Davis, manager of the Davis Financial Fund. One way is to ignore firms with overly complicated ways of making money.

The biggest holding in Davis's fund is Wells Fargo , one of the few banks to emerge stronger from the credit crisis. Unlike other big banks, which have extensive operations in investment banking and fixed-income and currency trading, Wells has a simpler model. It's the largest collector of retail deposits. That cheap access to capital allows the lender to be highly profitable without taking undue risks. Indeed, the company's return on equity—a gauge of how efficiently a firm generates profits—is more than twice as high as Bank of America's.

Think local. Like Wells, most regional banks "just specialize in taking in deposits and making loans," says Jason O'Donnell, chief investment officer for the Bluestone Financial Institutions Fund. What's more, a greater percentage of their deposits are in accounts that don't pay interest—think personal and business checking—compared with the major banks. Rising rates won't affect that business. Smaller banks are also less reliant on installment debt and fixed-income trading, which are vulnerable to rate increases, O'Donnell says. For low-cost diversification, go with SPDR S&P Regional Banking ETF . The fund holds 89 stocks in equal proportion, so the largest player—U.S. Bancorp, which is close to a major bank—doesn't dominate.

Play defense. The best-case scenario for this sector: The Fed raises rates because the economy is doing so well. And the worst case? The act of raising rates slams the brakes on the economy, slowing lending.

What type of company can thrive even when rates rise or when the economy slows? Insurers. Their business isn't dependent on a strong economy, and insurers profit from higher rates since they pocket interest income between the time they collect premiums and pay out claims.

Plus they "have demographics on their side," says Oppenheimer chief investment strategist John Stoltzfus. As global living standards rise and as baby boomers age, demand for life insurance and annuities will only grow, he says.

Shop on price. PowerShares KBW Insurance ETF charges only 0.35% in annual fees. And the average stock in this portfolio has a price/earnings ratio of just 11.7. That's 25% cheaper than P/Es for the broader financial sector.

Read next: By This Measure, Banks Are Safer Today Than Before the Financial Crisis