Key Points
- Banks and insurance companies generally have large cash holdings
- When interest rates rise this can be good for their profits
- A financial services ETF can be used to invest in a large number of these firms by holding a single share
It’s widely believed that there are going to be at least three US interest rate rises this year. This has caused global stock markets to plummet in recent days. As the Federal Reserve meets this week to give further guidance on increases to the cost of borrowing in the US market, I’m now looking at this financial services exchange traded fund (ETF).
How banks can benefit
Increasing interest rates are generally thought of as negative for the stock market. However, one exception is the financial services sector.
Banks are usually sitting on piles of cash from depositors and from their other business activities. They earn money from taking these funds and either lending them out or investing them.
When interest rates rise, financial institutions can benefit in two ways.
First, banks can charge more on loans and mortgages, but don’t usually pay savers much more interest. This means their profits should rise as they collect more money from borrowers than they have to pay depositors. Additionally, higher interest rates tend to reflect a period of greater economic growth. A stronger economy might mean that more consumers seek loans.
Second, they can make more money from investments, such as short-term government debt. US banks tend to invest in Treasury bills (short terms US Government debt) and these will now pay more.
The ETF I’m looking at
An ETF is a fund that tracks an index or sector and can be bought and sold like a share through most online brokers. It allows me to invest in a large number of companies by holding one stock.
The ETF I’m considering is iShares S&P 500 Financials Sector (LSE:UIFS). This fund aims to track the performance of the S&P 500 Capped 35/20 Financials Index. At present this contains 67 holdings, which represents the largest US financial services firms in the US.
The largest holding at just under 12% is Berkshire Hathaway. Warren Buffett’s company holds large cash reserves, has sizeable holdings in other banks and most importantly has a huge insurance business generating massive inflows of money in the form of customer premiums.
Performance and opinion
Over the last 12 months, this fund has performed strongly, increasing over 30%. Admittedly, year-to-date performance has not been great. Despite a good start to the year, at the time of writing, this ETF is down around 4%.
This serves as a note of caution for me. Though increasing US interest rates could be bullish for these companies, this fund is not immune to pullbacks in the general market. After all, in investing, nothing is guaranteed.
However, I feel the fall in the price over the last few days is a short-term blip. Historically periods of increasing interest rates have generally been positive for financial services. Once investors realise that 2022 might be positive for this ETF, I hope it will rise strongly. For this reason, I am seriously considering adding iShares S&P 500 Financials Sector to my own portfolio.