Banking on returns from financial funds

But flip the coin and you'll see banks on the verge of taking drastic measures to kick-start share price hikes - such as Barclays' biggest investors who are pushing for an axe to be taken to its investment bank. The banking sector might be down 64 per cent from the heady heights of its 2007 peak, but its efforts have resulted in a strong rebound in performance in recent months.

Turbulence of this severity might be enough to make you feel sick, but financial services is poised to be a cheap source of income for brave investors, according to a rising number of fund managers who are confident the sector will maintain a strong recovery.

FTSE banks are up 11.7 per cent over the last six months, compared with just 4.4 per cent from the FTSE 100. Well managed banks have been fighting tooth and nail to strengthen their balance sheets since the financial crisis, but much of this hard work has gone unnoticed as a significant number are still very undervalued - many due to political unrest caused by the eurozone crisis. Robert Mundy, manager of the Jupiter Financial Opportunities fund (ISIN: GB0004790191) - said they have been very good at trimming the excess fat off their businesses, shaping them into much leaner looking investments.

By focusing on core businesses and pumping profit back into businesses, at least three of the five leading UK high street banks are now on the verge of considerably increasing their dividend yield, says Thomas Moore, manager of the Standard life Income Unconstrained Fund and Standard Life Equity Income Trust.

It's fair to say Barclays is the flavour of the moment among fund managers with a depressed valuation, resilient 9 per cent equity returns and a booming Barclaycard business which they fondly describe as "world class". Its dividend yield is less exciting at 2.5 per cent, but Mr. Moore says it has real potential and is poised for a heady ascent. "Barclays is about to do what all banks should be doing - producing proper dividends."

HSBC and Standard Chartered are the highest-yielding UK banks, producing 5 per cent and 3 per cent respectively. Although these companies are not currently on depressed valuations, Mr Moore believes there is room for improvement as their balance sheets continue to gain strength.

But a large army of esteemed fund managers are still less than impressed by financial services. In an effort to shield private investors' money from the ongoing wrath of the sector, they remain underweight, or in some cases outright refuse to invest. "Why would anyone want to invest in banks?" asked Anthony Cross, manager at Liontrust's Special Situations fund. Describing their accounting as "strange" and business models as "not compelling", he says the political risk is too extreme to warrant significant investment. "The poor old man on the street had to bail them out and there's still significant backlash from that. That, coupled with their lack of long-term income stream through lending against the backdrop of regulatory threats, means they just don't make the grade for us."

Michael Clark, portfolio manager of the Fidelity MoneyBuilder Dividend, also has an underweight position in banks. He told Investors Chronicle: "The recovery process will take longer than many investors anticipate. We will probably need to see more write-offs and balance sheet restructuring before banks can rebuild dividend payouts. With continuing pressures on residential house prices, commercial property prices, and net interest margins from low interest rates, banks will struggle to return to a strong and sustainable level of profitability for some time."

While he does acknowledge banks are taking "encouraging steps" to restore the status quo to pre-credit bubble levels, his exposure to the banking sector is confined to HSBC, which he bought at an attractive valuation.

And James Thomson, manager of the Rathbone Global Opportunities fund, said he’s turned off by rock-bottom employee morale levels, shrinking loan books, and end-markets. "These are opaque business where the level of risk remains too high. I therefore continue to hold no exposure in the fund," he said.

With such extreme disagreement among managers it's hard to know whether danger will really give rise to opportunity as far as the banks go, although a glance at the track record of financial funds speaks volumes and should serve as a warning. Over a one-year performance period some of them look respectable but beyond this the full extent of 2008’s crisis is painfully mirrored, with all the top funds in the sector producing negative returns over a three- and five-year period.

Best funds for banking exposure

LOW RISK

If you want to gain good exposure to banks without applying excessive risk to your money, pure financial funds may be a step too far for some investors. While they may boast sturdy performances over a 12- or six-month period as banks have made a fighting come back, their long-term track records are still appalling.

You could consider a robustly performing fund with a high exposure to the sector, such as the Standard Life UK Equity Income Unconstrained fund (ISIN:GB00B1LBSR16), which is 18.29 per cent invested in financial services. Barclays and International Personal Finance are within its top holdings and the vast majority of stocks are UK-based. Its performance over a one- and five-year period is outstanding, and while its three-year performance isn't quite as startling, it is still very respectable. It has a total expense ratio (TER) of 1.8 per cent which is quite expensive.

If you'e looking for a fund with lower fees, the Jupiter Undervalued Assets fund (ISIN: GB0003237418) has a TER of 1.5 per cent and is also an outperformer with generous exposure to the financial sector (19.24 per cent). It holds Lloyds and Barclays within its top five holdings and has a good track record.

In the same sector, another strong performer (this time with stand-out three-year performance) is the Liontrust Special Situation fund (ISIN: GB00B0N6YF70) - a fund very underweight in financials (6.22 per cent). Its co-manager, Anthony Cross, favours consumer goods, technology, industrials and oil & gas. It's sensible not to exclude sectors altogether if you want a truly diversified portfolio, so this could be a good bet if you want to minimise risk from the sector, without excluding it completely.

An income option if you're cautious about banks is the Fidelity MoneyBuilder Dividend fund, (ISIN: GB00B3LNGT95), which is also underweight in financial services (11.8 per cent) and has none of the banks in its top 10 holdings. Investors Chronicle tipped the fund earlier this year as it has sustained divided growth over a number of years.

Meanwhile, Martin Walker's Invesco Perpetual Growth fund has excluded the sector all together from his top 10 holdings, despite having a liberal 18.14 per cent allocation to the financial services sector. So if you want exposure but don't want all your financial eggs in one basket, this could be a good compromise.

Performance of open-ended funds with exposure to financial services

HIGH RISK

If you do decide to go all out and invest in pure financial funds, the JPMorgan Global Financials fund (ISIN: GB0030877103) has pipped its rivals in terms of 12-month performance. With a 92.97 per cent allocation in financial services and 4.01 per cent in real estate, it is one of the purest financial services funds you can buy. Its top holdings include Wells Fargo, Citigroup, HSBC, Prudential and MetLife.

When you start looking at longer-term performance the picture gets much more depressing, although the AXA Framlington Financial fund (ISIN: GB0003499414) has minimal losses over a three-year period compared with its rival funds. It has a 77.37 per cent allocation to financial services (with 18.26 per cent in real estate) and is mainly invested in the US (32.79 per cent) and the UK (15.79 per cent). Its top holdings include HSBC, JPMorgan and The Commonwealth Bank of Australia.

How financial funds compare

Alternatively, if you prefer passive exposure, the db x-trackers MSCI World Financials TRN Index exchange-traded fund (Ticker: XWSF) is one to consider for global financials exposure. The ETF has has a total expense ratio of 0.45 per cent.

Top 10 MSCI World Financials TRN Index constituents