Canada’s Toronto Dominion Bank recently became the most shorted bank in the world, following the U.S. banking crisis. Are Canadian banks about to lose their luster? Unlikely.

What happened in the banking industry: A quick recap

You wouldn’t know it if you looked at overall stock indexes and volatility metrics, but the world just experienced its most significant banking crisis since 2008. The collapse of Silicon Valley Bank created a mass panic in the regional banking sector, and also caused Signature Bank to fail only days after the initial shock, as clients withdrew their deposits for fear of a repeat of SVB. Ironically this became a self-fulfilling prophecy, leading Signature Bank into insolvency overnight as well.

But as U.S authorities stepped in to contain the chaos, Europe’s troubles began with the collapse, and subsequent sale of Credit Suisse. To put the significance of this event into perspective, Credit Suisse is an institution that’s been at the forefront of the Swiss banking system since 1856, and had the backing of the Saudi National Bank. Although CS had its share of troubles over the past 10 years, it’s safe to say nobody expected its failure.

Is trouble brewing for Canada’s Banks?

With so much attention suddenly given to the banking sector, analysts, hedge funds, and investors quickly turned their eye to Canada’s banks, since it has managed to avoid these types of crises in the past. Although it’s often said that any publicity is good publicity, it didn’t turn out to be true for TD.
By April 3rd, TD had amassed a short position of $4.71 billion, making it the most shorted bank in the world.

But are there merits to this thesis? Should investors be worried? Probably not. Although Canada’s banking sector has been hit uniformly, TD’s stock in particular has suffered the most.

The thesis behind the TD short is somewhat unclear, but it seems to be a combination of a few factors:

1. Exposure to the housing market
2. Exposure to The Charles Schwab Corp
3. The acquisition of First Horizon

The first point on the list applies to nearly every bank in Canada and the U.S., so it doesn’t make TD any more attractive to short than other banks.
However, its exposure to Charles Schwab and First Horizon however may play a role in its recent underperformance. National Bank analysts have calculated that due to its exposure to Schwab, TD loses $1.8 billion in value for every 10% drop in Schwab’s price. This represents a roughly 1.5% hit to TD’s share price.
Lastly, the First Horizon deal is highly unlikely to go through in its original phase, considering the prices of its peers after the crisis. Therefore, depending on whether TD walks away from the deal, or is able to negotiate a lower price, it may or may not work out in its favor. In the event of a renegotiation, TD will come out ahead, having spent less than originally planned, for the same business expansion plans.

3 ways to take advantage of the recent weakness

There are three ways that investors can play the recent events, depending on their views of the future:

1. Ignore timing and find an ETF with the lowest exposure to TD, or that uses a mean reversion strategy to buy into banks that underperform
2. Try to time the event and find an ETF with the largest exposure to TD once it falls significantly, for the biggest upside capture on its recovery
3. Find a diversified financials ETF where each of the banks makes up below 10% of the holdings, and they are spread more evenly across the financials.

Scenario 1 - Hamilton Canadian Bank Mean Reversion ETF (HCA)

This ETF is best suited for those who believe TD will make a comeback in the near term.

The Hamilton Canadian Bank Mean Reversion ETF (HCA) makes use of the mean reversion strategy, which essentially relies on historical trends that show that Canadian banks often perform in line with each other, and any temporary under / overperformance in any individual bank stock will eventually return to the group mean.That is to say, banks that temporarily underperform, eventually start to trend back up to the mean.
The fund invests 80% of the portfolio in the 3 banks which have recently underperformed, meaning that investors who are betting on TD will get plenty of exposure given its recent performance.

Scenario 2 - Hamilton Canadian Bank Equal Weight Index ETF (HEB)

Equal weighted ETFs by definition have very similar weights allocated to their holdings, so any differences are minimal. However, these differences do seem to have an impact on their relative performance. In the case where investors want to time any potential news around TD, having the most exposure to its stock is the way to play it. The Hamilton Canadian Bank Equal Weight Index ETF (HEB) has a 16.4% allocation to TD, the most out of all available equal-weighted options. This has caused it to underperform relative to its peers, but it will likely outperform if TD comes back with a roar. HEB also has the lowest Management Fee at only 0.19%.

Scenario 3 - iShares Equal Weight Banc & Lifeco ETF (CEW)

Investors looking to get the most diversified exposure to the Canadian financial sector, and limit their individual exposure to TD, would benefit from investing in the iShares Equal Weight Banc & Lifeco ETF (CEW). The ETF invests in life insurance companies alongside Canadian banks, and limits each holding’s exposure at 10%, with all of the banks currently under this threshold. Any potential moves down in TD’s price would have a limited effect on the overall ETF, all else being equal. 

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.