Banking Deregulation No Panacea for Financial Sector Funds

Financial sector fund managers are licking their chops, watching lawmakers get ready to tear down outdated boundaries between banks, brokers and insurers.

The changes could usher in a freewheeling era of consolidation and turn many financial stocks into takeover plays. But despite the recent run-up of stocks in the sector, money managers say the outlook is anything but certain. And the possibility of rising interest rates insert an element of uncertainty that Congress can't legislate away.

The laws on the chopping block are the Glass-Steagall and Bank Holding Company acts, Depression-era laws designed to keep banks, brokers and insurers separate. Lawmakers have eroded the rules for years, but after a bipartisan compromise was hammered out last Friday, Congress is expected to erase these divisions completely. This will allow banks, brokers and insurers to merge or enter one another's businesses, offering a range of financial products and services under one roof, a la Citigroup.

On first glance, investors seem optimistic. From last Thursday's close through the end of trading Thursday, the American Stock Exchange Broker/Dealer Index rose 18.8%, the Nasdaq Financial Index was up 7.5% and the S&P Insurance Index was up 14.2%. But the boost may be exaggerated. TSC and others have hypothesized that some of these gains may be due to short-sellers frantically covering their bets that financial stocks would keep falling.

Financial sector fund managers hope the upswing is real and gives new life to a sector that was once hot but has fallen into a funk.

When consolidation among regional bank stocks started stoking the funds' performance 10 years ago, investors only had 10 funds to choose from. Since then, the average fund in the category returned more than 25% in 1991, 1992, 1995, 1996 and 1997, according to Lipper.

As usual, good performance sparked a flood of investment and a rush to open new funds. Today, there are 35 funds with nearly $15 billion in assets. But over the past year, rising rates and slowing consolidation have led to sagging returns and fleeing investors.

What Have You Done for Me Lately? Financial sector fund returns have tapered
Fund	YTD return/ranking	1-yr. return/ranking	3-yr. annualized return/ranking	5-yr. annualized return/ranking
(GFSAX)AIM Global Financial Services A	6.3% 3/63	25.2% 2/62	18.0% 6/26	14.9% 16/17
(RPFGX)Davis Financial A	-6.2 33/63	4.6 30/62	19.9 2/26	25.2 1/17
(FSFSX)Invesco Financial Services	-9.1 47/63	3.3 34/62	17.5 9/26	21.1 6/17
(FIDAX)J.Hancock Financial Industries	-11.0 51/63	-.2 47/62	11.8 22/26	N/A
(FIDSX)Fidelity Select: Financial Services	-3.5 20/63	7.7 19/62	19.2 3/26	23.7 3/17
Lipper Financial Services Funds Category	-5.7	5.3	15.8	19.5
Data as of Oct. 21. Source: Lipper.

That's It. I'm Outta Here! Annual net flows into financial sector funds ($mil.)
1994	1995	1996	1997	1998	1999 YTD
203.3	1,614.1	1,360.8	6,087.0	1,596.3	-4,580.4
Data as of Sept. 30. Source: Financial Research.

If deregulation spurs a wave of mergers, it could provide some real, sustainable gains for the sector, but it's anything but certain that these corporate marriages will actually happen or be successful.

The loosening of restrictions will allow banks, which typically sell insurance policies, to start buying life insurers and sell their own policies. Wells Fargo(WFC) and Fleet Boston (FLT) are likely acquirers because they're already distributing other companies' insurance products.

But not all agree. "I was talking to a guy in Wells Fargo's M&A department, and he said, 'Why we would we buy a life insurer? We make more money selling policies than we would making them,'" says Robert Shelton, portfolio manager of (GFSAX)AIM Global Financial Services fund.

Jeff Morris, portfolio manager of the (FSFSX)Invesco Financial Services fund, also is skeptical about bank-insurance mergers.

"A lot of people think banks will buy insurers," he says. "But I think we'll see more bank-to-bank deals. As of last year, there were over 8,700 banks in the U.S., and that's way too many."

He also foresees bank-brokerage mergers. Chase Manhattan (CMB), which agreed to acquire Hambrecht & Quist (HQ) on Sept. 28, may not be finished shopping. "Chase just bought H&Q, but they're not done. People want to see a Merrill Lynch (MER)-Chase combination, but Chase will have to wait for the dust to settle on Merrill's online transformation," Morris says.

Others think there might be more waiting than merging.

"Lots of people have M&A speculation now, but I think their expectations are too high," AIM's Shelton says. Many cross-sector partnerships already have formed over the past few years as the rules were gradually loosened, and most major banks already have brokerage subsidiaries, he notes.

And even if mergers occur, they aren't a cure-all. When businesses don't mix well, earnings estimates and stock prices can go down just as quickly as they have gone up.

"Banks often don't know how to run insurance companies or brokerages. There can be a deep, deep clash of cultures," says Bruce White, a private money manager with Clifford Associates in Pasadena, Calif. He cites Bank of America's (BAC) 1983 purchase of Charles Schwab (SCH) as an example. Bank of America failed to integrate the two businesses successfully and later jumped at the chance to make $200 million selling the brokerage back to its management in 1987. Last year, Schwab's revenue approached $3 billion.

Finally, an interest-rate hike could send the stocks south anyway. Interest rates typically pare financial companies' profits and induce sharp selloffs.

"There's a lot of ifs. Our market strategist says interest rates will rise. If that's wrong, financials will have good times. If that's right, they're in for a rough ride, no matter who buys whom," says Raphael Soiffer, a brokerage analyst with Brown Brothers Harriman in New York.

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