This week, investors all over the world are waiting to hear if the Federal Reserve will vote to increase interest rates...
The mere anticipation of rising rates has been unnerving investors over the past few months. Many investors are selling pre-emptively because the conventional wisdom says higher rates are bad for stocks.
But there’s an exception to every rule. Indeed, several areas of the financial sector would love substantially higher interest rates, including the insurance industry.
Before the financial crisis, insurers typically generated roughly 3% net interest margins, but thanks to more than six years of rate-squelching easy monetary policy, net interest margins have since plummeted to around 1%. The result: a progressively tighter squeeze on overall profit growth for insurers.
However, with many insurers are now trading at low earnings multiples -- often for less than book value. In general, cash flow is strong, dividends are rising and balance sheets are solid. So as interest rates rise, insurers should quickly begin to see nice profit gains, all else remaining equal.
Superior Upside Through Equal Weighting
To play the insurance industry’s coming profit resurgence, consider a broad-based investment with an exchange-traded fund (ETF). This provides exposure to all the key sub-sectors, such as life, health, property & casualty (P&C) and reinsurance. It also smooths out potential damage from major risks like higher-than-expected claims from natural disasters or overly aggressive investment choices that end up going south.
With invested assets of more than $530 million and second-quarter inflows of nearly $70 million, the SPDR S&P Insurance ETF (NYSE: KIE) is my choice to take advantage when interest rates start to rise. The fund, which carries a 0.35% expense ratio, tracks a benchmark -- the S&P Insurance Select Industry Index. That approach leads to an equally-weighted set of holdings, as opposed to most other funds that tend to weigh holdings based on market capitalization.
An equal-weight approach brings superior upside potential by giving each holding a similar effect on fund performance, while cap-weighting stresses the relatively few behemoths dominating any given industry. However, the juiciest long-term returns are usually found among faster-growing small- and mid-caps, which get much more clout in an equal-weight portfolio.
KIE is demonstrating this advantage, substantially outperforming its cap-weighted main rival, the iShares U.S. Insurance Fund (NYSE: IAK), over the past couple of years. However, both funds are beating the market, reflecting investors’ growing affinity for insurance stocks in the face of an expected steady rise in interest rates.
Per the fund prospectus, KIE’s objective is to mimic the risk and return characteristics of its benchmark, but without necessarily matching the index stock for stock. Rather, to help limit portfolio turnover and trading costs, the fund’s managers may purchase a representative sample of index holdings with the same overall performance profile as the index. At present, though, the fund has the same 50 stocks as the index, in similar proportions.
KIE’s average market cap of about $8 billion, compared with more than $19 billion for IAK, illustrates the smaller-company tilt that characterizes an equal-weight approach. So does the fund’s top holdings list, which is dominated by small- and mid-sized firms like StanCorp Financial Group Inc. (NYSE: SFG), First American Financial Corp. (NYSE: FAF) and The Hanover Insurance Group Inc. (NYSE: THG).
Despite their smaller size, these three firms are significant forces in the health insurance, specialty (e.g., title insurance) and P&C markets, respectively. Their combined five-year rate of return of 21% is common among the industry’s smaller players.
As a diversified fund, KIE does include top large-cap insurers like P&C leaders Chubb Corp. (NYSE: CB) and Progressive Corp. (NYSE: PGR), Dow component The Travelers Companies Inc. (NYSE: TRV) and industry giant American International Group Inc. (NYSE: AIG). But because they’re typically slower-growing, large insurers like these occupy less-prominent positions in KIE, whereas they’re all top holdings in IAK.
Better Performance And Higher Yields
While it’s no surprise that KIE’s smaller-company focus is producing outperformance, you wouldn’t expect a higher yield from the fund, too, since smaller stocks tend to pay slimmer dividends. Yet the fund’s current yield of 1.7% is actually slightly greater than IAK’s 1.5% yield.
StanCorp, for example, more than doubled its dividend over the past decade to $1.30 a share. First American’s payout is up more than fivefold to $0.98 since the firm initiated its dividend in 2010. Both companies have very low payout ratios, though, suggesting there’s plenty of room for generous dividend raises in the years ahead, as well.
Another welcome surprise: KIE has been no more volatile than IAK over the past five years despite an emphasis on smaller stocks, which usually fluctuate in value to a greater extent than larger ones. But in this case, equally strong dividends are likely helping to dampen stock-price variations.
Risks To Consider: Insurers regularly face headwinds that could offset the benefit of higher interest rates, such as stricter regulations that increase operating costs or soft market conditions with lower policy pricing.
Action To Take: The increasing robustness of the U.S. economy puts heavy pressure on the Fed to move interest rates steadily higher in coming quarters. As that scenario plays out, look for the SPDR S&P Insurance ETF to continue to deliver solid gains.
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