Spread your risk with a financials fund

UK banks have more work to do on their remuneration policies but have growing appeal for investors who favour companies able to deliver long-term sustainable growth strategies, adds Ian McVeigh, manager of Jupiter UK Growth Fund (GB0004792130).

"Although bank shares have risen strongly in the past couple of years, their share prices still look undervalued," he says. "The industry is highly regulated, but we believe they can unlock more value by a better alignment of interests between staff and shareholders. Much has been done to reduce excessive pay and bring the reward to be more evenly split between staff and shareholders."

Financials account for a third of Jupiter UK Growth's assets and the largest holding is Lloyds, which accounts for 8 per cent.

Read our tip on Jupiter UK Growth

Meanwhile, Rob Burnett, manager of Neptune European Opportunities (GB0032308594), is investing in financials, including banks, in countries such as Italy. Over the first quarter, the fund's top contributors included Italian banks such as UBI (It: UBI) and Banca Popolare Di Milano (It:PMI). Financials account for more than a third of the fund's assets.

Mr Burnett has concentrated the fund on domestically-focused stocks and sectors, "which - given the ongoing European economic recovery - we believe offer potential for the greatest earnings growth and stock market outperformance. And earnings growth can be found at a much cheaper price in some of the more domestically focused areas such as financials and utilities, sectors in which we remain overweight. The European peripheral countries are currently trading on very attractive valuations, while still demonstrating strong earnings growth, particularly in the financials space."

However, fund manager Neil Woodford, who had been cautious on banks for a long time, which was of benefit during the financial crisis, still has his reservations. "I do not have a religious aversion to banks, but in general they are exposed to many pressures that keep me out of wanting to invest in them. I am not convinced there will be a tailwind for banks globally for a long time. I don't think we will get an adequate level of dividend from Lloyds, Royal Bank of Scotland (RBS) and Barclays for a very long time."

But he does hold HSBC (HSBA) in St James's Place UK High Income Fund (GB0007667776) and may also invest in HSBC with CF Woodford Equity Income Fund, which launches on 2 June. "This is the first bank I have held since 2003, which I believe is undervalued," says Mr Woodford. "HSBC is much further down the path of repair than the other UK banks, and I believe it can continue to build its capital base and reduce its leverage, and grow the dividend. It is on the same rating as it was in the depths of the financial crisis, but is well managed and has learned from its mistakes. It is a cheap share. I initially bought it mid-way through 2013, and as I grew more confident I have built it up to around 2 per cent of assets."

He also owns life insurance company Legal & General (LGEN), which he says he has not owned for a long time.

Read our interview with Mr Woodford

With opposing arguments for investing in banks and a number of concerns over the sector, it can be difficult to decide whether to invest. But a solution might be a financials fund. These invest across all financial sub-sectors - not just banks - so while you get good exposure to these, financials funds' fortunes don't totally rely on them. Financials are a fairly diverse sector which encompass a number of different companies - for example, asset managers, brokers and various types of insurers.

"The financials sector as a whole is decent value," says Darius McDermott, managing director at broker Chelsea Financial Services. "Stock markets are reasonably strong which supports asset managers, and asset management stocks have been doing very well as stock markets improve, examples being Schroders (SDR) and Henderson (HGG), although Aberdeen (ADN) has suffered due to emerging markets outflows. Meanwhile, more trading benefits brokers such as ICAP (IAP), while life insurers are good dividend payers. The banks had to recapitalise, but now the better ones could be good investments. There has already been an investment case for the banks, but now there is even more visibility with them and there could be a second leg of performance to be had."

The financials sector is generally geared to improving economic growth and there is an improving economic outlook. "You could consider a financials fund if you want to buy into the economic recovery and exposure to this sector," suggests Mr McDermott.

Risks

If interest rates rise aggressively and there are defaults on assets such as mortgages and other debts, this would be detrimental to banks. UK, US and European banks also face stress tests to see if they have enough capital to withstand certain scenarios which may force them to hold more capital, cutting into their profits. Banks that fail stress tests may have to raise money from investors, scrap dividends or sell assets to make up their capital shortfalls. A recent example is Deutsche Bank (De:DBK) which is seeking €6.3bn from a rights issue.

As some banks undergo restructuring, it is unclear how well their management teams will complete the task. Mick Gilligan, head of research at broker Killik, says that different banks will have divergent fortunes.

And since the financial crisis there has been more government intervention in banks because in the UK and other countries they own substantial chunks of certain banks, which can be unpredictable.

Non-life insurers may not be so profitable if there is a catastrophe and they have to pay out insurance claims, while UK insurers involved with annuities may lose business as government reforms broaden retirement options.

Read more on annuity changes

If there is a dip in securities trading brokers' revenues are hit.

A financials fund diversified across the sub-sectors helps mitigate the risks of any one area, but Mr McDermott still suggests you do not invest more than about 5 per cent of your assets in a single strategy such as a financials fund. You are likely to already have exposure to financials via your broader-based regional and global funds, which are the first port of call for most investors. If that exposure is not enough you could then buy a financials fund as part of a broad well-diversified portfolio if you have a higher-risk appetite.

Open-ended financials funds tend not to offer attractive yields, so they are not a good option for income seekers.

Financials funds

Mr McDermott suggests Jupiter Financial Opportunities (GB0004790191), which has outperformed the MSCI All Countries Financials Index over the past year. It has 30 per cent of its assets in banks and more than 10 per cent in life insurance, mostly in North America where it has 43 per cent of its assets. The fund is well diversified with 105 holdings. The largest, Mediobanca, only accounts for 3 per cent of assets.

Jupiter Financial Opportunities' managers Guy de Blonay and Robert Mumby are very experienced at investing in financial services and have good long-term records.

Tom Jemmett, analyst at Brewin Dolphin, suggests Aptus Global Financials (GB00B796C343), which is globally diversified and offers good exposure across various financial sectors. The fund is less than two years old but has outperformed the MSCI World/Financials Index over one year.

Mr Gilligan suggests Polar Capital Global Financials investment trust (PCFT). "This can take advantage of a number of less liquid opportunities," he says. "The team have also done well in the past and are experienced."

Investment trusts do not have to meet investor redemptions like open-ended funds, so they can buy investments that are less easy to trade, which gives them more options and a longer-term investment horizon. Polar Capital Global Financials also offers a yield of 3 per cent in contrast to open-ended financials funds, but trades on a slight premium 0.25 per cent, albeit lower than its 12-month average of 3.95 per cent.

Other approaches

If you are not happy about allocating to a single sector fund, some broader funds have a significant allocation to banks alongside a diverse range of other holdings. These are potentially less risky because they are less focused. "But you need a meaningful weighting if you think financials is the sector to be in," says Mr McDermott. "You need to have a fund that is overweight its benchmark index."

As well as Old Mutual UK Alpha, Jupiter UK Growth and Neptune European Opportunities, options include Majedie UK Income (GB00B7FRND86). Its largest sub-sector exposure is life insurance, which accounts for 14.7 per cent of assets, while banks account for 5 per cent, financial services 12.8 per cent and non-life insurance 8.5 per cent.

Mr Gilligan says other funds with significant exposure to financials include FP Argonaut European Alpha (GB00B4ZRCD05), which has about 23 per cent of its assets in this area. Its top five holdings include Bankia (Sp: BKIA) (6.8 per cent), Intesa Sanpaolo (It:ISP) (5.9 per cent) and Piraeus Bank (Gr:TPEIR) (5.2 per cent).

In March, its managers made a significant investment in Banco Commercial Portugues (7.1 per cent of assets) and initiated a new purchase in Bank of Ireland. "As the macro environment becomes less hostile, we believe that European domestic cyclicals that have aggressively restructured during the downturn now offer the most compelling opportunities given the scope for corporate profit recovery," they said.

Source: Morningstar as at 26 May 2014

Source: Morningstar as at 26 May 2014

UK domiciled funds with the highest exposure to financials

Source: Morningstar