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 Buffett's Berkshire Hathaway, mortgage giant Wells Fargo, and credit-card issuer American Express.
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% smaller.
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 latter.
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 managers.
What drives financials?
With the above in mind, you probably won't be surprised to hear that the financial sector has two principal profit drivers.
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 followed Financial Select Sector SPDR ETF, has underperformed the S&P 500 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.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends American Express and Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.