By Ben Baden

A slower-than-expected recovery and regulation have depressed the shares of many bank stocks

For investors, there may not be a more complex or confusing sector than financial services. Big banks are still trying to clear the remnants of the financial crisis from their balance sheets. Meanwhile, governments throughout the world have pledged to reform and regulate the sector to prevent future crises. Combine these things with a weak economy, and it's no wonder that the sector has struggled in 2010. Year-to-date, the average financial sector fund has returned only 0.6 percent, compared with a 1 percent gain for the S&P 500.

The latest financial reform talks took place earlier this month in Basel, Switzerland, where regulators from different countries -- including the United States -- agreed on capital requirements for banks that were considered fairly lenient by most analysts. Bank stocks rallied on the news early last week. "Most of the major banks have already largely met most of the requirements within that, and there's plenty of time for those that haven't to shore up their financial situations and add to their capital ratios before the required date," says Brad Sorensen, director of market and sector analysis for the Schwab Center for Financial Research.

The picture is improving for big banking, experts say, but a lot of uncertainty remains. Most is related to the creation of the new Consumer Financial Protection Bureau, which is charged with putting an end to abusive financial products. No one is certain as to how far the bureau will go in accomplishing that goal. "[The bureau has] been given a pretty broad mandate," says Jim Sinegal, associate director of equity research at Morningstar. "They can regulate unfair, abusive, or deceptive practices. As far as what that covers, no one really knows."

It's also unclear how further consumer protection regulation could affect the profitability of the banks. "There's already talk that some of the services that consumers have gotten used to, such as free checking, higher interest-bearing checking accounts, and free bill pay -- that they may have to start paying for those things," Sorensen says. "Whether they'll be willing to, and whether the financial sector can come up with ways to replace those revenues -- that's something we'll have to watch as we go forward." Sorensen expects a tough road for financials over the next few months. The sector's performance will depend on whether the economy improves and also on the regulatory mood after the mid-term elections in November, he says.

Sinegal agrees: "The issue is not 'are the banks going to survive?' [It's] 'how profitable are they going to be over the next few years?'" He says he sees potential upside for the big banks because much of the news about the economy has been negative for some time. The bad news, Sinegal says, has depressed the share prices of many of the big banks.

With that in mind, here are three of U.S. News's top-ranked financial sector funds. Each manager takes a unique approach to investing in the financial sector.

Burnham Financial Industries (BURFX)

This is the only fund of the three in which the manager has the option to short -- or bet against -- financial stocks. Manager Anton Schutz employed the shorting strategy during financial meltdown, and the fund lost only 7 percent in 2008 (compared with a loss of 37 percent by the S&P 500 index). "It was good to have that short-selling ability during the depths of the crisis," he says. Lately, Schutz has been buying big banks like Citigroup. "The big banks are really cheap on any measure you want to put them on," he says. These banks have underperformed recently, Schutz says, because of the threat of further regulation. When the dust settles, he believes they could be poised for higher returns. "At the end of the day, the balance sheets are in great shape ... and [mergers and acquisitions are] returning," he says. Other than big financial firms, Schutz likes a few regional players, including two Florida-based banks 1st United Bancorp and CenterState Bank. Over the past five years, the fund has returned an annualized 6 percent, ranking it in the top 10 percent of its category. Its annual fees are 1.88 percent.

Royce Financial Services (RYFSX)

You won't find the likes of JPMorgan Chase or Goldman Sachs in this fund. Manager Charles Royce says his team is unique because they doesn't invest in any of the big banking names. "We've made a specialty out of virtually everything else," he says. Occasionally, Royce will invest a small portion of the fund in smaller banks, but in general, banks are too complex for his liking. Instead, Royce looks to other areas of the sector like investment management firms. Currently, Royce counts AllianceBernstein and Invesco among its holdings. "The demographics are positive for the money management world as people's savings are increasing dramatically out of the recovery," he says. The fund has returned an annualized 2 percent over the last five years. That's good enough to put the fund in the top 10 percent of its category. It charges annual fees of 1.49 percent.

Prudential Financial Services (PFSAX)

The fund is subadvised by Mark Lynch of well-known investment shop Wellington Management. Unlike the other two funds on this list, Lynch invests significantly outside the United States. Currently, about 75 percent of the fund's assets are in shares of foreign companies. "[Lynch] mostly has been avoiding banks in countries with crippling deficits, as banks tend to have large exposure to the sovereign debt of home countries," says Morningstar analyst Harry Milling. Recently, Lynch has been investing in big banks in countries like Canada, France, and Switzerland. Some of the fund's largest holdings include UBS (Switzerland), BNP Paribas (France), National Bank of Canada, and Wells Fargo. Lynch runs a fairly concentrated portfolio; as of the end of August, the fund held only 47 stocks. Over the past 10 years, the fund has returned an annualized 8 percent. Its annual fees are 1.66 percent.

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