Tempted by the Rally in Financial Stocks? Don’t Discount the Risks

Financial services stocks have staged a major rally in recent days, surging more than 20% since Oct. 15 and raising the question: Is the yearlong slump in the financial sector--and the mutual funds that focus on those stocks--finally over?

Though they’re still the third-best-performing category of stock funds this decade, financial services sector funds have posted weak results for nearly two years.

Whereas the typical U.S. diversified stock fund is up more than 8% year to date, financial services funds are up just 4%, on average--even including their phenomenal surge last week. And last year wasn’t much better: Financial funds enjoyed less than half the gains of the typical domestic stock fund in 1998.

The main problem, of course, has been rising interest rates, which have depressed bank stocks. But there is another culprit partly caused by higher rates: a bear market in insurance stocks. From May 14 to Oct. 15, the Standard & Poor’s index of life and health insurance stocks slumped nearly 24%.


Today, the typical financial services fund invests nearly 20% of its assets, or $1 of every $5, in the insurance sector, according to fund tracker Morningstar Inc. Some funds invest quite a bit more.

This makes the pending passage of sweeping legislation that would repeal Depression-era financial services laws that much more important to these funds and their shareholders. That’s because life insurance companies--with depressed stock prices but well-established sales distribution channels coveted by banks and asset managers--may stand to be the biggest beneficiaries of the proposal, analysts say.

Most of the attention surrounding this legislation has centered on the fact that it would repeal the 1933 Glass-Steagall Act, which has made it difficult for commercial banks and brokerages to merge. But the proposal would also do away with the 1956 Bank Holding Company Act, which has kept commercial banks and insurance companies from joining forces.

Once both of these barriers are removed, it should spur another wave of mergers in the financial services sector, this time led by deals between banks and life insurance companies, analysts say. The prospect of this alone could drive up financial stocks in general, many experts say.


“It certainly has stimulated [the stocks] in the last few days,” notes Marc Halperin, co-manager of the Federated Global Financial Services fund.

Indeed, since the House, Senate and White House reached a general compromise on the proposal on Oct. 22, the Standard & Poor’s financial stock index has surged 10%.

The huge gains in the financial services sector over the last decade have been largely fueled by declining interest rates and by the unprecedented wave of bank consolidation. There are now fewer than 10,000 banks in the United States, 5,000 fewer than a decade ago. “And in the next five years, a third of those [remaining] will go away as well,” says Halperin.

Also, “we’ve had a fair amount of consolidation between regional banks and regional brokerages,” says Thomas Goggins, co-manager of the John Hancock Financial Industries fund.

“Now,” says Goggins, “we see banks buying life [insurance] companies. That’s where we see the potential opportunities.”

To be sure, none of this is a “slam-dunk,” says Scott Cooley, an analyst with Morningstar.

For instance, David Dreman, manager of the Kemper-Dreman Financial Services fund, worries that most investors are still fixated on only the largest financial services stocks, the “glamour stocks” such as Chase Manhattan or Citigroup. “There’s been almost no liquidity in smaller [regional] banks and insurance companies,” he said.

And even if banks start buying up insurers--or vice versa--what good will it do investors if interest rates continue to rise?


Traditionally, rising interest rates have been seen as detrimental to financial services firms’ earnings. For instance, when rates rise, banks have to pay their depositors more to attract and maintain assets.

But, says Michael Lipper, president of mutual fund tracker Lipper Inc. in New York: “I think you’ve got to look at this analysis that interest rates going up is bad for financials. It’s not totally true.”

While banks may have to pay out more to depositors as rates rise, they can also charge borrowers more. In fact, the margin between the prime lending rate and 30-day bank certificate of deposit yields “has pretty much been fixed,” says Goggins.

Contrary to the popular wisdom, “increased interest rates [alone] do not impact bank or insurance company earnings,” he says.

But interest rates also drive, and reflect, the economy. If rising rates put the economy in recession, than that will absolutely have an impact on financial company earnings and the stocks.

In a recession, of course, the number of loans that go bad spikes up sharply, cutting into bank profitability. The number of bond issuers that default usually also rises, jeopardizing financial services firms’ investment portfolios.

All of this highlights the cyclical nature of financial stocks, and also the dangers of blindly going into a financial services sector fund this late in an economic expansion, and with the continuing threat of higher interest rates.

But if you’re comfortable with the risks, there are several financial services funds worth looking at. The following funds all recently held substantial stakes in insurance stocks (more than 20% of stock assets). Among them:


* Davis Financial A (4.75% load; minimum initial investment: $1,000; [800] 279-0279; year-to-date total return: 5.1%; 3-year annualized return: 24.5%).

* T. Rowe Price Financial Services (no load; minimum initial investment: $2,500; [800] 638-5660; YTD return: 5.6%; 3-yr. ann. ret.: 22.5%).

* Invesco Financial Services (no load; minimum initial investment: $1,000; [800] 525-8085; YTD return: 2.2%; 3-yr. ann. ret.: 22.1%).

* John Hancock Financial Industries A (5% load; minimum initial investment: $1,000; [800] 225-5291; YTD return: -1.3%; 3-yr. ann. ret.: 16.0%).

* Kemper-Dreman Financial Services A (5.75% load; minimum initial investment: $1,000; [800] 621-1048; YTD return: 0.3%; 1-yr. tot. ret.: 12.7%).

If you’re banking on a pick-up in insurance stocks and want to be more aggressive, there are a few financial funds that invest either exclusively or primarily in insurance stocks. Among them are the $340-million Century Shares fund (no load; minimum initial investment: $500; [800] 321-1928; YTD return: -10.3%; 3-yr. ann. tot.: 16.3%), which recently had more than 80% of its stock assets in insurers; and the $49-million Fidelity Select Insurance fund (3% load; minimum initial investment: $2,500; [800] 544-8888; YTD return: -4.2%; 3-yr. ann. ret.: 21.0%).

Do you have ideas for mutual fund and 401(k) topics for this column? Times staff writer Paul J. Lim can be reached at


Money in the Banks

Thanks to falling interest rates, financial services sector stock funds have been the third-best-performing category of stock mutual funds in the last decade, trailing just technology and telecommunications portfolios. Yet in recent years, with rates rising, these funds have struggled. Annual total returns:


Average Financial Services Sector Fund

Through Oct.28: +4.0%


Average U.S. Diversified Stock Fund

Through Oct.28: +8.4%


Source: Morningstar Inc.