Key points
- US inflation is at a record high and could result in faster and steeper interest rate rises
- This might be good for the profits of banks and insurance companies
- A financial services ETF can be used to invest in a large number of these firms by holding a single share
As US inflation reaches its highest level in 40 years, some market analysts think that the US Federal Reserve might have to raise interest rates sooner and more aggressively than first thought. Against this backdrop, this fund, focussed on US banks and insurance companies, is one of my best exchange-traded fund (ETF) picks right now.
How financial institutions can benefit
These firms in the finance sector are usually sitting on lots 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, they 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, financial companies can make more money from investments, such as short-term government debt. US banks tend to invest in Treasury bills (short-term US government debt) and these will now pay more.
A best ETF pick
The ETF I’m looking at 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, representing the largest US financial services firms.
The largest holding at just under 13% 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. The second and third largest holdings are JP Morgan Chase and Bank of America, at around 10% and 8% respectively. Both of these are multinational investment banks and financial services companies.
Over the last 12 months, this fund has performed strongly, increasing over 30%. However, year-to-date performance has been subdued. Because of the general pullback in the financial markets this year, at the time of writing, this ETF is pretty much flat.
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 the normal up and downs of the stock market. After all, in investing, nothing is guaranteed.
However, historically periods of increasing interest rates have generally been positive for financial services and that’s why iShares S&P 500 Financials Sector is one of my best ETF picks right now. For this reason, I’m seriously considering adding this fund to my holdings as part of a balanced portfolio.
