Financials funds: too cheap to ignore or still risky?

Ritu Vohora, investment director at M&G Investments, says that although it is human nature to feel comfort in the safety of numbers, there are risks in following the crowd when making investment decisions.

"Crowded stocks tend to have an asymmetric return profile," she says. "Incremental positive news is generally of little benefit, because there is little room to improve on already high expectations. Conversely, negative news carries much more downside risk given stretched valuations. The reverse is true of oversold companies: already negative sentiment puts a floor on negative revisions, while positive surprises provide powerful impetus on the upside."

And financials could well be in this position, according to Darius McDermott, managing director at Chelsea Financial Services.

"European banks are probably the reason the asset class is unloved and are on very low valuations - typically 0.5 price to book," he explains. "That is historically low for banks. One might argue that at those low valuations there is little downside risk, although I wouldn't say there is no downside risk."

John Yakas, manager of Polar Capital Global Financials Trust (PCFT), suggests the negative press coverage the banking sector has received over the past few years could be masking opportunities for investors.

"One of the problems is that the noise around the sector is still quite negative," he says. "What we find is actually there are some banks in decent shape, which are growing their dividends and have got yields of 5 to 6 per cent. Considering this is an environment where people are desperate for income, the sector looks attractive from that perspective."

There are a number of other reasons why he thinks income-seeking investors might want to look twice at global financials funds.

"People have linked financials to interest rates so it will be quite a strong catalyst if we get even a slight rise in US rates," he says. "The lower interest rates are, the less money banks make on free funds, so if rates rise you will see it flowing into their margins."

His trust has just under 20 per cent of its portfolio invested in US banks, which will benefit from even a quarter of a percentage rise in interest rates, he adds. And he thinks that Europe is another area where sentiment is excessively negative, especially as European banks are now better capitalised than they have been in the past.

"Most balance sheets are now in much better shape," he says. "We're getting to a point where some are beginning to have surplus capital, and to pay that money back in terms of dividends and buybacks. As a sector, it's looking quite interesting in terms of capturing that progressive growth in dividends."

However he believes the concerns around southern European banks, particularly Spanish, Italian and Greek ones, are justified as residual problems about their capital adequacy remain.

But financial technology companies capable of disrupting the sector and generating strong growth offer opportunities, as do the growing middle classes in emerging markets, where financials are still a growth industry. "The range of opportunities on offer shows that investing in the global financial sector is not just about banks," he says.

"The financial sector is far more diverse than just banks: it includes insurance companies, reinsurance companies, exchanges, credit cards, leasing companies and asset managers," adds Mr McDermott. "Even within banks, there are different types, for example investment banks, everyday retail banks, local banks, regional banks and challenger banks - so [investors] need to put that into context."

Reasons to avoid financials

However other investment analysts feel the global macroeconomic backdrop of sluggish growth and record-low interest rates means it is right for investors to avoid financial funds, as the industry's profitability is likely to suffer.

"With negative interest rates across a number of jurisdictions and ultra-low rates elsewhere, this is bad news for banks resulting in margin erosion," says Jason Hollands, managing director at Tilney Bestinvest. "And while UK banks are in a much better capital position than European banks, they face uncertainty around their future passporting rights within the European Union (EU) and may potentially have to undergo the costs of restructuring to adapt to a post-Brexit world."

Although he agrees it is important for investors to recognise the broader range of companies within the financial sector, it is equally important to understand the risks attached to each subsector.

"In the near term, asset managers are going to be boosted by the support to stock and bond markets from quantitative easing in the UK, EU and Japan," explains Mr Hollands. "And UK-based managers who run sizeable books of overseas assets should also benefit from the weaker pound as their costs are primarily based in Sterling, but many of their assets under management are exposed to other currencies.

"They are also incredibly vulnerable to a market correction, which many observers believe is long overdue given the duration of the bull market and stretched valuations. The share prices of asset managers typically magnify the movements in underlying stock markets as their fortunes are so interlinked."

By contrast, he thinks UK life insurance companies might fare better than other types of financial companies, due to the steady nature of their premiums and the government's auto-enrolment programme.

However Mr Yakas prefers non-life insurance companies over life insurance companies, saying he is concerned current low interest rates could come back to bite life insurers further down the line.

"We're quite light on life insurance generally as a sector because I think the very low rate environment from a strategic perspective raises questions as to how these guys are going to make money in the long term," he says. "They've written obligations on the assumption that investment returns would be much higher than they are today. With banks there are much shorter-term liabilities, so in some ways they have a lot more freedom to manage themselves in a slightly different investment environment."

Life insurers are also less transparent with the nature of their accounting and disclosure making them harder to analyse.

Mr Yakas says the two biggest risks are further regulation, which could force banks to increase capital reserves and potentially cut dividends, and US interest rates not rising. But he believes it is now relatively easy to see which banks do not have enough capital to weather changes in regulation, using stress testing models. And delayed rate rises in the US would lead him to focus on opportunities elsewhere - particularly in Europe.

"Remember if interest rates stay low, European banks may outperform because for them the environment is slightly different - they want to spark a little bit of loan growth - so keeping rates low might help that happen," he explains.

But there are also risks in investing in European financials. "Banks in Europe have not really resolved their problems," says Adrian Lowcock, investment director at Architas. "There is a crisis going on in the Italian banks, massive issues in some German banks and the potential that all this bubbles to the surface so you have a proper run on banks in Europe. The risk is that, say, one of the Italian banks collapses causing a contagion effect, which we saw during the high peak of the financial crisis. That looks unlikely, but it's a risk that is not really appreciated."

How to invest

Nevertheless Mr Lowcock thinks investing 1-2 per cent of your portfolio in financials funds could be worthwhile as long as you can stomach volatility and plan to invest for at least five years.

"It's not just the UK, Japan or southern Europe, and US and northern European banks are doing relatively well," he explains. "You want a specialist manager in this space, because the balance sheets are so complicated that you'd need an expert - somebody who knows this stuff and can analyse it inside out. And an active manager can make decisions and switch between areas, depending on what the change in sentiment, performance and outlook has been."

Mr Lowcock particularly likes Jupiter Financial Opportunities Fund (GB00B5LG4657)*. "The manager, Guy de Blonay, is keen to emphasise that this isn't just a portfolio of bank shares and is not a high-beta strategy at all times," says Mr Lowcock. "The fund will invest in companies that have one of three profiles: high yield, growth or restructuring. These have very different risk/return characteristics and don't shine in the same market conditions. This ensures the portfolio is balanced and can offer investors some protection."

Investors can also gain exposure to this area by investing in a fund with a wider remit but which has a high allocation to financials. Mr Lowcock picks outs FP Crux European Special Situations Fund (GB00BTJRQ064)* and Schroder Recovery (GB00BDD2F190), a value-style fund that has more than 28 per cent of its portfolio in financials.

"FP Crux European Special Situations holds some investments in Scandinavian banks, which navigated the financial crisis very well because they'd been through their own crisis back in the early 1990s and they're now managed in a very pragmatic, conscientious way," says Mr Lowcock. "The manager's philosophy isn't about buying banks or countries in Europe. It's about buying good companies hence he's focused on some Scandinavian banks, which he thinks are well-run businesses."

For funds with sizeable investments in financials Mr McDermott also highlights Schroder Recovery, alongside Jupiter UK Growth (GB00B54CH949), which has 22.6 per cent in financials, and River & Mercantile UK Equity Long Term Recovery Fund (GB00B614J053) which has 26 per cent in financials.

He also likes Jupiter Financial Opportunities Fund and Polar Capital Global Insurance Fund (IE00B61MW553) as a specialist option in this area.

"There are certain sub sectors [within financials], such as the global insurance or reinsurance industry that are interesting," says Mr McDermott. "Polar Capital Global Insurance has a very good long-term track record and it's earning over 10 per cent a year, so it's certainly worth consideration [despite] being concentrated in one of the subsectors of financials."

*IC Top 100 Fund

Funds offering financials exposure

Source: Morningstar as at 07/09/16