Since they facilitate the flow of capital and debt, financial companies play a crucial role in oiling the wheels of the global economy and due to the fact it permeates almost every aspect of corporate and personal life, the vast financial services sector has been dubbed the ‘nervous system of capitalism’.

Candidly, this sector has a reputation for being, well, a bit dull, yet financials have a role to play in investors’ portfolios as they tend to generate stable cash flows and dish out dependable dividends.

Given the sheer breadth of the space, the sector’s constituents offer portfolio builders diversification, although its stocks are typically sensitive to economic downturns and volatile markets and the sector is not immune to ‘Black Swan’ events, as demonstrated by the GFC (global financial crisis) of 2008, which marked a turning point for financials.

Since the crash, financial stocks have gradually recovered. Banks have strengthened their balance sheets, reduced risk and improved operational efficiency, while disruptive fintech companies offering innovative financial products and services have also emerged.

A STRONG BACKBONE

Banks form the backbone of the diverse financials sector, providing essential services such as deposit taking, lending and payment processing, but insurers, asset managers, investment platforms and exchange operators also make the cut alongside an array of exciting fintechs.

There are two key earnings drivers in the financials sector, namely interest rates and the velocity of financial transactions which is fuelled by consumer confidence and the health of the underlying economy. Financial stocks tend to perform well when yield curves are steep, regulatory environments favour banks, and credit markets aren’t under strain.

As the chart shows, the MSCI All Country World Index Financials sector has outperformed the wider All Country World Index this year, so while there is a lot to like about the sector, investors should be mindful of the price they pay for stocks which have rallied hard year-to-date.

Martin Connaghan, co-manager of Murray International (MYI), informs Shares: ‘Interestingly, the financial sector has been one of the best-performing areas of the markets year to date, particularly since it has been banks that have been leading the charge, with this subsector outperforming the areas of insurance and diversified financials. It’s interesting because we’ve already seen considerable rate cuts in Europe with the expectation that, except for Japan, interest rates are to fall globally towards the end of this year and into next.’

As such, Connaghan warns investors to be ‘mindful of the direction of interest rates moving forward and the impact this could have on net interest income for the banks.’

FundCalibre’s Darius McDermott says financials have enjoyed a strong run recently thanks to rising interest rates, which have boosted bank profit margins, and resilient economies that have kept loan demand steady.

‘As long as a recession is avoided, funds specialising in this space can continue to perform well,’ argues McDermott, ‘as a stable or growing economy lifts investor confidence and drives demand for banking, insurance and broader financial services.’

David Eiwert, manager of the T. Rowe Price Global Focused Growth Equity Strategy, says the financials sector, and US large cap banks in particular, is ‘what we term a “good Trump pond”. This means that the Trump administration is likely supportive of these institutions, possibly leading to regulatory changes that could benefit them. There’s the possibility of relaxing some of the constraints around capital and other regulatory adjustments. We have optimism about regulatory changes in the financials sector, particularly in the US, that could boost banks - the lack of a traditional credit cycle, along with other factors like government spending and low energy prices, creates a positive environment for financials stocks.’

DIVERSIFY YOUR EXPOSURE

A global equity income trust with a value bias, Connaghan says Murray International’s financial exposure is well spread across three sub-sectors with banking stocks in Singapore, Thailand and Italy. Insurance holdings in Ping An Insurance (Hong Kong), Tryg (Denmark) and Zurich Insurance (Switzerland). Exchange businesses Hong Kong Exchanges & Clearing (0388:HKG) and CME (CME:NASDAQ) finish off the trust’s exposure to financials.

‘It would probably be these two businesses that fall into the “exciting us” camp,’ says Connaghan. ‘There is a lot to like about exchange businesses. They have considerable barriers to entry, high margins, strong cash flows, and generate excellent returns.’ CME, the world’s largest derivatives exchange operator and the leader in futures trading in the US, is the most prominent financials position in the portfolio as of 31 July 2025.

‘CME’s products include futures and options on futures on interest rates, equities, energy, FX, metals, and other commodities,’ enthuses Connaghan. ‘The macroeconomic uncertainty that market participants have been trying to negotiate has been very supportive of the average daily volumes that exchange companies like CME have been seeing. CME also usually pays out a special dividend at the end of the year, which puts it on a reasonable yield for an exchange company, something that is very important for Murray International given the investment objective.’

Nigel Hikmet, co-portfolio manager of the Developed Markets UCITS Strategy at Lansdowne Partners, adds: ‘One of our highest-conviction ideas at the moment is UK and Irish banks. We believe there are two basic truths of banking that are often forgotten. First, it is an industry that tends to grow at least in line with nominal GDP over time. Secondly, economies of scale are incredibly powerful, both from cost efficiencies - only increasing with artificial intelligence - and because new business flows tend to be less profitable than the sticky stock of customers, rendering new entrant economics poor. As a result, incumbents earn higher returns and gain market share over time, organically or via consolidation.’

Hikmet believes that after 15 years of extreme stress for the industry, ‘this norm is reasserting itself – as businesses have simplified, consolidated and interest-rate extremes corrected. While many banks posted strong returns in recent quarters, those returns remain understated due to interest rate hedges. As these hedges unwind in the coming years, and banks are exposed to higher rates, we expect continued positive momentum. In combination with balance-sheet growth outpacing cost inflation and share buybacks at low valuations, the growth of earnings possible for the sector is compelling.’

STRUCTURAL GROWTH OPPORTUNITIES

Insurance is another area where Hikmet sees potential for a ‘profound structural opportunity. Relative to other financial services, personal (car/homes) insurance is unusual - large corporate clients offer higher returns than retail customers. Following recent consolidation and regulatory changes, this could reverse, especially if the value of data in risk analysis develops as we would anticipate. We also think that changes in interest-rates and the maturing DC pension market could allow ROE (return on equity) for the savings business to rise appreciably.’

BUYER BEWARE 

A dissenting voice is Paul Middleton, global equity portfolio manager at Mirabaud Asset Management, who warns that financials have ‘begun to flag to us as being expensive, with price earnings ratios for the sector at 10-year highs of 13 times. Fundamentals are also not as good as they have been in some areas, with a hard pricing market in US Insurance beginning to roll over. We therefore think it pays to be more selective, and some of the slightly more defensive names stand out to us as looking attractive here.’ One example is Murray International favourite CME, which Middleton says should continue to do well if market volatility remains elevated and pays an attractive 3.8% yield.

Eiwert sees potential opportunities in European banks due to the steepening of the yield curve, changes in regulation and low valuations. ‘Some European bank stocks are really cheap and unowned, and even though some have already performed well, they may still have upside potential if their thesis proves correct,’ says Eiwert. ‘During the period of market volatility in April, we added to US and European financial sector exposure, as we see financials as a promising area for potential growth.’

Also weighing in is Brendan Gulston, co-manager of the WS Gresham House UK Multi Cap Income Fund (BYXVGS7), who steers clear of banks due to their inherent cyclicality and sensitivity to interest rates, which he says places too much of the value creation outside management’s control. ‘Instead, we prefer capital light financial services businesses where long-term structural trends are driving opportunity. The UK wealth management sector is a growing market underpinned by structural drivers such as rising household wealth, an advice gap, and government policy, making it a long-term attractive thematic opportunity to deploy capital.’ 

KOREAN BANKS – DEEP VALUE & DIVIDEND UPSIDE 

Redwheel, which manages Temple Bar (TMPL), believes Korean banks currently offer some of the most attractive value opportunities globally, while the dividend outlook for the sector remains ‘exceptional’. Among the trust’s new positions are several Korean lenders which enjoy ‘steady loan growth in a growing economy, are efficiently run and have strong capital ratios’ according to Redwheel’s Ian Lance and Nick Purves. ‘Both undertake prudent lending policies and offer attractive shareholder returns and yet they also are valued at historical price earnings ratios of around seven times and large discounts to net asset value.’

Gulston also sees upside in Sabre Insurance (SBRE), which has a 20-year-plus track record in specialist motor underwriting leveraging its proprietary datasets. ‘Due to its sustainable competitive advantage, Sabre has consistently generated attractive margins relative to the insurance industry and pays a substantial dividend,’ observes Gulston.

FundCalibre’s McDermott is a fan of the Polar Capital Global Insurance (B5339C5) fund, which gives investors ‘targeted access’ to the non-life insurance sector, a specialist, often overlooked part of the market. ‘Insurance is embedded in our daily lives, regardless of the economic cycle, giving this fund strong defensive characteristics,’ stresses McDermott. ‘Its long-term track record and focus on quality make it a great diversifier for income and total return investors alike. The sector’s dominance within the FTSE 100 has also helped drive the UK market higher this year. Investment trusts City of London (CTY) and Schroder Income Growth Fund (SCF) both maintain a significant overweight to financials, with holdings such as HSBC (HSBA) and Lloyds (LLOY) among the top positions across both funds.’

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