Financial sector headlines are often dominated by banks and insurers. But there is one area that has emerged as a steady grower and dividend payer: financial exchanges. 

Exchanges’ gains contrast against steep declines in the broader financials sector, where traditional banks in particular have grappled with ultra-low rates and a slowing global economy. Over the past several years, many exchange operators across the globe have seen strong share price rises, including Nasdaq, the London Stock Exchange Group and Hong Kong Exchanges and Clearing.   

We think exchanges are solid companies that offer a number of attractive characteristics for both growth- and income-oriented portfolios. These businesses typically have high barriers to entry, high margins, low capital spending needs and strong free cash flows. They have returned plenty of capital to shareholders, and shares of most companies provide some yield. And compared to banks, exchanges have required less operating capital and have provided greater returns on invested capital.

Financial exchanges have outpaced the broader market

Source: RIMES, MSCI. Company and index returns rebased to 100 as of November 30, 2005. Data reflects period from November 30, 2005 through November 30, 2020.

 

Three growth pillars

The global exchange industry has undergone a major transformation over the past 20 years. 

Some exchanges went from being public utilities to publicly traded commercial enterprises. Trading shifted from crowded pits on exchange floors to high-speed online networks. Several rounds of consolidation swept the industry. There’s also been a data boom from algorithmic and quant trading. At the same time, the investing class has grown around the world, and exchanges have seen rising trading volume from both retail and institutional investors.   

Going forward, we believe three industry growth pillars are:

1. Trading 

Trading is a high-margin business, with EBIT (earnings before interest and taxes) margins averaging 60% for the industry. Futures are the largest and most attractive asset class, while cash equities are mature with stable pricing. Most important for an investor, these high margins require low levels of capital and yield healthy amounts of free cash flow.

In terms of trading, CME Group, parent of Chicago Mercantile Exchange, dominates futures trading for example and its shares have offered an attractive yield. The company’s vision is to expand on a global scale and deliver innovative product development, such as the recent launch of the Micro E-mini futures which enable trading in smaller sized contracts.

The operator of the Hong Kong Stock Exchange, Hong Kong Exchanges and Clearing, is another example of a company that relies heavily on trading for its overall revenue. The exchange has played an important role in facilitating Chinese corporate access to foreign capital, and it’s not easy to replace it with the Shanghai or Shenzhen exchanges, making it unique among global exchanges and giving it a monopoly-like stature. Trading volumes are likely to increase through the addition of more Chinese technology companies such as recently listed Alibaba and Meituan Dianping, as well as a trading link that connects the Hong Kong Stock Exchange with institutional investors in mainland China.

 

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
• Depending on the strategy, risks may be associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.