The SMSF army has enjoyed a remarkable return from investing in Australia’s banks. Not only have banks led the market higher in 2015, with the financial index up 10.51% compared to the broader market’s 8.70%, the performance over the last three years is staggering.

While the broader market has averaged gains of 14.48% over the last three years ending 30 January, the financial sector has returned 24.52% per annum. An outperformance of over 10% per annum – no wonder so many SMSF trustees are overweight the banks!

While I have been a huge fan of bank shares, I think it is now time to lighten your holdings and move to index weight. This doesn’t mean sell all your bank shares – but rather, just ease back a touch and move to a more normal position.

What’s a normal position? Well, if you are an index hugger, this means that your exposure to stocks in the financial sector would be 41% of your total share portfolio. Of this 41%, the four major banks make up 31% – with AMP, Macquarie, Challenger and the regional banks accounting for the remaining 10%. So, if your exposure to the four major banks is around 30% to 40% of your share portfolio, then you are around index weight.

Why index-weight?

Firstly and most importantly, it is inevitable that the banks will need to increase their capital base. David Murray’s Financial Systems’ Inquiry Report hasn’t gone away. Rather, we are in the period where the Government is considering feedback (due by 31 March), consulting with APRA and then deliberating on the recommendations. While this process may run for some months, the Government will eventually come down on the side of the Inquiry.

It is absolutely inconceivable that a Treasurer or APRA chair could chose to ignore these recommendations.

Banks will probably be given an extended timeframe to reach the new capital target, so it is not as though the market is going to be immediately flooded with dilutive capital issues. However, higher capital targets will eventually mean lower EPS (earnings per share), and this will act as a drag on bank share prices.

A clue to the banks’ thinking was revealed by the Commonwealth Bank last week, which chose not to neutralize their dividend re-investment plan by buying the shares back on market. In February last year, CBA went down the same route and copped such a hiding from the analysts, it reversed its position for the dividend paid in October. Hardly a squeak this time.

NAB has also gone down this path, and has further re-invigorated its DRP with shares now offered at a 1.5% discount and no cap on the participation level.

Secondly, the lower Australian dollar will eventually be a positive for a number of other stocks, cyclicals in particular, and if this market keeps moving higher, my sense is that the major banks will start to lag. Also, you want to be lightening when others are still buying.

So, why not go below index-weight and be underweight bank shares? I think the risk reward equation doesn’t yet stack up. It looks like we will see one more interest rate cut, and if the economy remains stagnant and the Government pre-occupied with leadership squabbles, a second or third cut may come onto the agenda. In these circumstances, further yield compression will drive bank share prices higher – yields of 4.25% to 4.5% could start to look attractive.

How to lighten

The easiest way to lighten is not to buy any more, and let the percentage weight of bank shares fall as the portfolio grows.

So, exit all your bank dividend reinvestment plans (CBA shareholders can still make this change for the forthcoming $1.98 interim dividend).

If you can deal with any capital gains tax issues (remember, this won’t affect a fund in pension, and in accumulation, the tax rate for holdings held for more than 12 months is only 10%), then take advantage of the rally and sell some of your bank shares.

Which bank to sell?

I have reviewed the major bank shares three times over the last nine months. On 19 May, I ranked the banks in the following order: 1. CBA, 2. Westpac, 3. ANZ and 4. NAB. I reviewed this again in August, and made one minor change, I switched ANZ and NAB around, elevating NAB to third place. In November, I kept the ranking the same, although noting the differences were at the margins.

Nine months has passed since my first ranking, and despite being the most expensive stock on a PE basis, CBA is the clear outperformer (see table below). NAB has jumped into second place, while ANZ is the laggard.

So, which bank will outperform, or in regard to the question above, underperform from here?

The brokers

Let’s start with the brokers.

To be honest, I have zero confidence in the broker bank analysts. As a group, they have been horribly, horribly wrong about the major banks. If you had listened to them, you would have been short Commonwealth Bank and long National Australia Bank for the last decade – and lost thousands!

However, maybe they will get it right one day……………..

Listed below are the consensus broker ratings from FN Arena. With sentiment measured on a scale of -1.0 (most negative) to +1.0 (most positive), NAB is the most favoured and CBA is the least favoured. On forward multiples, CBA is trading at multiple of 16.7 times earnings – an effective premium of almost 25% to the ANZ.

Source: FN Arena as at 13/2/15. Sentiment scale (-1.0 to +1.0)

My view

I see no reason not to continue to back the Commonwealth. While 16.7 times is a heady multiple, their half-year result was outstanding. Best capitalised, best return on equity, market leading cost to income ratios and positive jaws – underlying revenue growth of 6% in the half year, underlying expense growth of just 3%.

NAB is a recovery story and the new CEO, Andrew Thorburn, is making all the right noises. While the quarterly trading update was a little disappointing, the higher yield and lower PE multiple make it hard to anoint NAB as the bank to sell.

ANZ and Westpac will provide trading updates in the next two weeks, so with this caveat, I am inclined to rank these two at the bottom. Westpac has just appointed a new CEO, while ANZ is likely to start a search soon to replace Mike Smith. With the weakest capital ratio, a reluctance to invest in core banking technology and challenges with their Asian investments, it is no surprise that ANZ is now the cheapest bank on a PE basis.

That’s also the way I see it – so if you need to lighten, sell ANZ, with Westpac a close second.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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