In our bottom-up process of evaluating stocks for our portfolios, we seek balanced exposure to multiple sectors while maintaining high active share with a relatively low tracking error. At times, however, there are market opportunities that warrant emphasizing a single sector and allow us to do so efficiently.

The financial sector presents an investment opportunity

We believe such an opportunity exists in today’s environment, which is evolving to reward the financial sector across three drivers that underpin its business model: interest rates, balance-sheet risk and regulation.

1. Interest rates: The accommodative monetary policies of central banks in the last six years have been a consistent headwind for most financial sector businesses. Though we do not expect a dramatic hike in interest rates anytime soon, we do believe that we are entering a multi-year period in which rates will drift higher on the back of increasing inflationary pressures from wages and a changed motivation from the U.S. Federal Reserve to “normalize” its policy stance. We realize that this is a tenuous forecast, but the wind seems to be changing direction, in our opinion. The Fed wants to raise rates—and banks, insurance companies, and consumer financiers are all poised to benefit.

2. Balance-sheet risk: Across the financial sector, balance-sheet risk has declined dramatically since the financial crisis in 2008, in our estimation. This decline is largely a result of higher capital requirements, stricter loan-underwriting standards and a reduction in leverage—especially among many of the largest banks. In the last stress test administered by the Federal Reserve (whose results were published in October 2014), banks had to demonstrate their resilience in an extremely adverse—though unlikely—scenario of concurrent shocks to the banking system, such as a severe recession accompanied by high unemployment, a spike in energy prices, and a collapse in the stock and real estate markets.

So how did the largest banks fare on that test? The tier 1 common equity ratio1 (a critical measure of a bank’s financial strength and a cushion against risk) for all 31 participating banks dropped from 11.9% to 8.4%, which is about double the amount of capital that banks had at the trough of the financial crisis by the end of 2008, and a similar level to what they had during 2001-2007. In other words, what used to be the “base case” (or most likely) prognosis for banks in an adverse scenario is now the worst case, which indicates a major improvement in banks’ resilience. We view this result as highly favorable given the rigorous nature of the test banks had to pass, the Fed’s conservative assumptions about their performance, and banks’ improved underwriting standards and lower leverage.

One outcome that we see from banks’ reduction in risk exposure and higher supportive capital is that many of the largest financial institutions may present some of the most attractive investments in the market for income growth, while overall price volatility declines. If this scenario materializes, financial stocks could become a compelling substitute for current dividend-paying stocks, such as utilities and real estate investment trusts (REITs), which are generally more expensive.

3. Regulation: We believe the regulatory backdrop is finally starting to shift. U.S. policymakers in both parties are becoming more open to the idea of more flexible regulation to support economic growth, without increasing the risk that the financial sector poses to the country’s economic well-being. For example, there has been recent talk about reducing the size threshold for banks that require the annual Comprehensive Capital Analysis and Review (CCAR) exam, and about a slight loosening of mortgage underwriting rules. We also see evidence of fewer high-profile law suits and major bank penalties.

Each of these “big-picture” drivers—interest rates, balance-sheet risk and regulation—seems to be changing gradually. A favorable and simultaneous evolution in all three can have a powerful effect on financial-stock valuations (which are currently low), and we believe they may contribute to sector outperformance over the next several years.

1 Tier 1 common equity ratio is a measurement of a bank’s core equity capital compared with its total risk-weighted assets.