Not all cyclical assets are created equal, as the performance of different sector funds over the last year demonstrates. The likes of Schroder ISF Global Energy (LU0355356832) and BlackRock World Mining Trust (BRWM) have made enormous gains in the 12 months to 8 July 2022 as commodity prices have skyrocketed. Financials funds, by contrast, have sold off fairly heavily this year despite their status as obvious beneficiaries of the rising interest rate environment in which investors now find themselves.
The extent of the pain has varied from fund to fund, and if the 9.7 per cent loss racked up by the SPDR MSCI World Financials UCITS ETF (FNCW) in the six months to 8 July looks bad, a more extreme case can be found in the investment trust space. Shareholders in the Polar Capital Global Financials Trust (PCFT), the only UK-listed closed ended vehicle with a specific focus on the financials sector, are sitting on eye-watering paper losses of 21.5 per cent over the same period. Over a year they are down by around 12 per cent.
Portfolios like this are a good example of how competing macroeconomic narratives can make life complicated for investors. Viewed as a direct beneficiary of rising rates, banks were growing in popularity just a year or so ago – only to sell off this year as more serious concerns kicked in about the debilitating rise in the cost of living and the increased likelihood of a recession.
In the case of PCFT, the trust has gone from comfortably exceeding a £100mn fundraising target in 2021 to seeing its shares fall out of favour: they traded on an 8 per cent discount to net asset value (NAV) on 11 July, a long way out from a 12-month average premium of 0.5 per cent. After a brief moment in the sun, the fund appears to have once more become an option for the contrarians.
A contrarian buy?
Bear market conditions mean that many trusts have seen their shares trade on wide discounts relative to their own recent history of late, and any bargain hunters currently active will understandably wish to be selective. But beyond the discount itself, there are a few arguments to be made for this particular trust.
One, outlined in its results for the half year to the end of May, relies on inflation subsiding relatively quickly but higher interest rates spurring wider net interest margins and higher profitability for banks, as well as higher investment income for insurance and life assurance companies. As the update adds: “Higher inflation should also mean that loan growth is stronger as businesses have to borrow more money to cover the increased costs of their working capital or capital expenditure. Equally, it should lead to higher insurance premiums to cover the increased cost to repair insured risks.”
Things could pan out very differently. As the same results acknowledge, that is just one macroeconomic scenario, and not all of the alternatives look so rosy for the portfolio. If inflation were more durable than current forecasts, for one, it would hurt markets and the financials sector, with potentially grim consequences for PCFT's returns.
“Central banks would have to raise interest rates significantly and potentially hold them at a higher level for longer. Equity markets would likely de-rate further and, while bank shares outperformed wider equity markets during the 1970s (arguably the most relevant period for comparison), they would not be immune to concerns around the impact on economic growth,” the investment team notes in the report.
As they add, the outlook has seemed mixed. The results do cite weak consumer confidence surveys and anecdotal evidence that lower-income households are struggling with rising inflation, but adds that these gloomy indicators have been “at odds with what banks are seeing from customers”, with Bank of America (US:BAC) noting in its first-quarter earnings that average customer deposits had moved higher than they were before the pandemic. Those customers who had between $1,000 and $2,000 in their bank accounts in 2019 more recently had an average cleared balance of $7,400, with the figure stretching even higher for those who had higher balances before the lockdown era. As the IC's Hermione Taylor recently observed ('Can household savings save the day?' IC, 8 July 2022), the health of the economy could well depend on whether consumers dip into such savings now – in the US as well as the UK.
|The trust's top 10 holdings on 31/05/22|
|Bank of America||4.2|
|Source: Polar Capital Global Financials Trust|
One broader note of optimism for the sector is now well known, and hinges on the idea that banks are now much more resilient than they were at the time of the financial crash, having de-risked and repaired their balance sheets.
But for those considering the portfolio's merits, it’s also worth highlighting that the Polar Capital fund has taken a more risk-off stance in recent times, too.
The six-month period covered by the results has seen the investment team cut back its allocation to banks from 66.7 to an admittedly still chunky 59.7 per cent of the portfolio, while exposure to more defensive companies such as insurers has increased.
The team more generally cut back on positions seen as more sensitive to market volatility such as JPMorgan (US:JPM), Citizens Financial (US:CFG) and UBS Group (CH:UBSG), while initiating positions in defensive names such as Visa (US:V) and topping up on positions in the likes of Berkshire Hathaway (US:BRK.B), Chubb (US:CB) and Wells Fargo (US:WFC). The team views some names, such as Royal Bank of Canada (CA:RY), as more defensive than their sector peers.
The investment managers also cut back on European bank exposure as an initial response to the Ukraine crisis while reducing the level of gearing in the portfolio. The results note that gearing came down to 3.7 per cent over the period covered, having already fallen from a high of 12.7 per cent in November 2020 to 5.2 per cent at the end of November 2021.
In terms of its major geographical exposures, the trust had just under half its assets in North America at the end of May, with 19.5 per cent in Asia Pacific ex-Japan, 15.4 per cent in Europe and 10.7 per cent in the UK.
Comparing the competition
While it maintains a niche in the investment trust space, PCFT is certainly not without rivals from the wider funds universe. One well-known active name is the open-ended Jupiter Financial Opportunities Fund (GB00B5LG4657), which has recently had less of a focus on Asia and a greater allocation to Europe. The Jupiter fund has struggled even more than PCFT in recent times, although it certainly raced ahead in 2019 and 2020. The funds have relatively similar levels of concentration when it comes to the level of assets accounted for by their top 10 positions, a proportion that came to 31.8 per cent for PCFT and 39.8 per cent for the Jupiter portfolio at the end of May.
A bigger problem for the trust is that it has failed to beat an equivalent tracker fund. As the chart shows, the Polar Capital trust's share price total return has failed to outpace the SPDR MSCI World Financials ETF mentioned earlier ever since the trust launched in 2013. That’s despite the sometimes advantageous traits of the closed-ended structure, from the use of gearing to a lack of liquidity concerns and the ability to delve into small caps and even unquoted stocks.
There are other points of difference: the exchange traded fund (ETF) isn't hugely concentrated, as a glance at its biggest 10 positions will indicate, and recently had 222 holdings versus 77 in the trust at the end of May.
In the shorter term, PCFT's weaker relative performance likely relates to its heavy exposure to banks and its limited exposure to the more defensive insurance sector. But as Killik & Co’s head of managed portfolio services, Mick Gilligan, notes, the longer track record shortcomings may serve as a good example of how higher fees can erode your end returns.
“Total ongoing charges of above 1 per cent plus a performance fee are one reason for this,” he says of the underperformance, adding: “The performance fee is a relative one and this is likely to deter the managers from taking positions that are too large relative to the index.”
Gilligan does not use the trust in his firm’s managed portfolio service, noting that he already has adequate financials exposure via certain value-oriented trusts such as UK income stalwart City of London (CTY), which recently had a quarter of its assets in the sector. On the ETFs front he would suggest the Xtrackers MSCI World Financials UCITS ETF (XWFS), which has a slightly lower fee than the SPDR ETF. We have used the latter as a comparator for the trust because of its longer track record.
All that said, it is worth considering another advantage PCFT has versus its rivals. The dividend yield recently came to a not unattractive 3.2 per cent, roughly in line with that on the relevant ETF and well ahead of that available on the Jupiter fund. As Gilligan notes, the trust has a progressive dividend policy that should reward investors in the future.
“The PCFT board is keen to maintain and grow the dividend level where possible and it has used reserves to maintain last year’s dividend level,” he says. The most recent figures show the trust having enough revenue reserves to cover around eight months’ worth of its annual dividend payout.
Other details warrant some consideration. With its exposure to insurers and even some fintech plays, the trust offers much better diversification than investors might find by including the likes of UK banks in a portfolio. But its performance versus passive options continues to underwhelm, and investors who back it will have to have faith in the prospect of the share price discount closing, or the team’s ability to make the most of the investment trust structure in the future.