Over the last few years, the financial sector has gotten a bad
rap. And understandably so. The greed and selfishness permeating
its ranks at the beginning of the century culminated in the worst
financial crisis since the Great Depression. Indeed, had it not
been for the adroit maneuvering of policymakers at the Federal
Reserve and Department of Treasury, things easily could have
turned out even worse.
But any negative sentiment toward the financial sector
shouldn't be interpreted to mean that it isn't a critical piece
of America's commanding economic engine. Make no mistake about
it, a modern economy cannot exist without a well-developed
financial system. And, at least for the time being, the United
States has the best in the world of both.
What is the financial sector?
The financial sector contains companies that provide financial
services to retail customers and businesses. It includes some of
the biggest and best-known firms in the world including Warren
, mortgage giant
, and credit-card issuer
While the business model of its constituents differs, the
fundamental commonality is that they all act as financial
intermediaries. Banks take customer's deposits then loan them out
to individuals and businesses in need of capital. Asset managers
allocate the funds of their clients into investments. And real
estate investment trusts employ capital raised in the equity
markets, combined with debt from other financial institutions,
and buy physical property or asset-backed securities.
It's for this reason the financial sector is oftentimes
referred to as the "nervous system of capitalism." Despite its
well-publicized indiscretions over the past decade, there's
simply no doubt it's an essential piece of a modern economy.
How big is the financial sector?
To say the financial sector is huge doesn't do it justice.
With a combined market capitalization of $7.1 trillion, it towers
over the nine other commonly recognized sectors. The next
biggest, companies in the technology space, is a full 26%
Even though these are massive figures, however, they still
understate the sector's true size and breadth. The bank industry
alone oversees $13 trillion in deposits, $15 trillion worth of
owned assets, and a staggering $20 trillion in assets under
management. It is, both literally and figuratively, the vault
that stores America's wealth.
After the bank industry come insurers, with a combined market
cap of $1.15 trillion. Then capital markets and real estate
investment trusts follow in short order. And bringing up the rear
is a handful of smaller industries that deal in consumer finance,
real estate, and other types of financial services.
How do financials work?
There are two general types of business models that prevail
throughout the financial sector. The first model relies on
arbitrage to generate revenue and thereby earnings.
Technically speaking, arbitrage is the process through which
pricing discrepancies between comparable assets are exploited.
For instance, if corn is selling for $4.50 a bushel in Kansas
City but $5.00 in St. Louis, then one could theoretically turn a
profit simply by buying corn in the former and selling it in the
And so it is at banks, insurance companies, real estate
investment trusts, and other members of the financial sector. For
instance, banks arbitrage interest rates. They borrow funds at
low short-term rates, largely from depositors, and then lend the
very same funds out at higher long-term rates. Real estate
investments trusts do the same thing, though their funding source
derives from the capital markets and not deposits.
The second type of business model is oriented toward services
-- and, for the record, many financial companies use both types.
This model charges fees for services provided. If you've ever
paid closing costs on a mortgage or car loan, then you're likely
familiar with this. And the same is true of brokerages and asset
What drives financials?
With the above in mind, you probably won't be surprised to
hear that the financial sector has two principal profit
The first are interest rates. Because a large share of the
sector makes money by arbitraging short- and long-term rates, the
precise relationship between the two makes a big difference. More
specifically, the bigger the so-called spread between the two,
the better. On top of this, because interest rates are inversely
correlated with the value of fixed-income investments, the
direction of the former has a considerable effect on portfolio
values across the sector.
The second driver is the velocity of financial transactions --
which, it's worth pointing out, is fueled by consumer confidence
and the health of the underlying economy. If you're a brokerage
company that makes money by charging customers per stock trade,
then the more trades the merrier. And the same is true for
mortgage companies that charge fees to originate home loans.
The bottom line on financials
To be clear, the fact that the financial sector is a critical
piece of America's economic engine doesn't necessarily mean it's
a good place to invest your money. Since the beginning of the
21st century, the sector as a whole, represented by the widely
Financial Select Sector SPDR ETF
, has underperformed the
by more than 30%.
At the same time, there are standout players that have
trounced other investment alternatives. Buffett's Berkshire
Hathaway offers a textbook example. Consequently, just as is the
case in any other sector, it's important for investors to be
selective about what you invest in. Do your homework. Invest for
the long run. And let the chips fall as they may.
Financials: Investing Essentials
originally appeared on Fool.com.
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