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The funds that benefit from higher interest rates

Financials are cheap but investors need the right mix of stocks to stay safe
January 12, 2023
  • Banks are better capitalised and can profit more on borrowing so are able to pay larger dividends
  • Diversified UK equity income funds are still a better option for income investors than financials funds
  • Financials funds could be a good option for growth and value investors because this sector is relatively cheap and should benefit from higher interest rates

Banks’ recovery from the financial crisis proved long and painful. In the immediate aftermath, they needed more capital and liquidity, for example, and had to pay heavy fines for past misdeeds. But these problems are now largely resolved and recent higher interest rates are helping banks fund large dividend payments and share buybacks.

“Banks make most of their profit by charging borrowers more for their loans than the bank pays to its depositors – the net interest margin,” notes Rob James, co-manager of Premier Miton Financials Capital Securities Fund (GB00BMWVS771). As interest rates fell after the global financial crisis, so did the interest earned on loans. The problem arose on the deposit side of the balance sheet. With banks unwilling to charge their customers interest for deposits, the interest rate on deposits stopped falling once it reached zero. As a result, the net interest margin fell relentlessly for the entire period and there was little the banks could do, other than focus on their cost bases. But now the tide has turned."

This is getting the attention of income investors. David Smith, manager of Henderson High Income Trust (HHI), recently commented that "investors could see the best dividend growth in more cyclical sectors despite the prospects of a recession. While there is always a risk that the regulator may limit dividend payments from the banks as it did during the pandemic, given the strength of capital ratios and more stringent lending standards over the past decade, we believe they can still afford higher dividends even in a more difficult economic environment."

This trust had 22.6 per cent of its assets in financials at the end of November, and its top 10 holdings included NatWest (NWG) and private equity group 3i (III), which accounted for 2.7 and 2.4 per cent of assets, respectively.

Higher interest rates can also result in accelerating demand for bulk purchase annuities, benefiting insurance companies.

However, income investors should not necessarily rush into bank stocks and financials funds. "I don't naturally think of financials for income and governments can stop bank dividends," says Darius McDermott, managing director of Chelsea Financial Services. "When you get a crisis, regulators overreact and not all banks are the same."

For example, while Lloyds Banking (LLOY) had an annual dividend yield of 4.4 per cent and Barclays (BARC) 3.6 per cent, Standard Chartered's (STAN) was lower at 1.5 per cent, as of 9 January.

Financials funds do not only invest in banks but rather across various types of companies in different subsectors, including exchanges, platforms, financial technology, reinsurance and insurance, which may not all be strong dividend payers. And yield is not most financials funds' primary focus.

An exception is Polar Capital Global Financials Trust (PCFT), which aims "to generate a growing dividend income together with capital appreciation" and had a yield of 2.8 per cent as of 9 January, according to Winterflood. It was also trading at a discount to net asset value of around 5 per cent, so investors in the trust benefit both from its shares and its holdings being relatively cheap.

Polar Capital Global Financials had 56.8 per cent of its assets in banks at the end of November, with about a fifth in insurance companies and 12.5 per cent in other types of financial companies. It takes advantage of opportunities worldwide, mainly in developed markets. At the end of November, 47.4 per cent of its assets were in North America, with 21.7 per cent in Asia and 14.7 per cent in Europe ex UK. Its 10 largest holdings included JPMorgan (US:JPM), Bank of America (US:BAC) and HDFC Bank (IN:500180), in which it had 5.4, 4.5 and 3.7 per cent of its assets, respectively.

An alternative, more obvious option for income investors, particularly those looking to benefit from bank dividends, are UK equity income funds, argues McDermott, because they "tend to go where there is yield, are value orientated and contrarian".

He highlights GAM UK Equity Income (GB00BF09N571), which has a good record of outperforming the FTSE All-Share index and had a yield of 4.2 per cent as of 9 January. It has no restrictions on which sectors or size of company it invests in, and had over 30 per cent of its assets in financials at the end of November. Its top 10 holdings included HSBC (HSBA), Barclays and Lloyds Banking, which accounted for 4.3, 3.7 and 3.6 per cent of its assets, respectively.

But unlike some UK equity income funds, it is not principally focused on large caps, with nearly a third of its assets in FTSE 250, 11.2 per cent in small-cap and 10.7 per cent in Aim stocks, at the end of November.

Artemis Income (GB00B2PLJJ36) had 30.6 per cent of its assets in financials at the end of November, with 3i and London Stock Exchange (LSEG) among its largest holdings, accounting for 6 and 4 per cent of its assets. The fund had a yield of over 4 per cent as of 9 January.

City of London Investment Trust (CTY), which has increased its dividend payments for 56 consecutive years, had nearly a quarter of its assets in financials, with top 10 holdings including HSBC at the end of November.

 

When financials pay

Financial stocks could be of particular interest to growth and value investors for the reasons set out above. "If you subscribe to the central bank rhetoric that rates might stop going up but stay higher, financials could do quite well," adds McDermott. "With a higher interest rate environment there could be a tailwind for financials for the next two years."

But because financials funds are diversified across various subsectors they have exposure to areas that can do well in different circumstances. For example, when markets are doing well asset manager stocks can do well and exchanges may benefit when volatility is high.

Financials are also relatively cheap overall: as of 30 December, MSCI World Financials index had a price/earnings (PE) ratio of 12.9 against 17.1 for MSCI World index. It also had a dividend yield of 3.1 per cent against 2.2 per cent for MSCI World.

These are reasons for value investors – who seek to invest in stocks that appear to be trading for less than their intrinsic value – to consider financials. "Banks and financials have not been popular and lagged for the past 14 years," says McDermott "But they beat MSCI World in a rising market in 2021 and falling market in 2022. Given that they are cheap and have a nice yield, and interest rates are higher they look like a good place to be."

The MSCI World Financials index returned -10.2 and 27.9 per cent while MSCI World returned -18.1 and 21.8 per cent in 2022 and 2021, respectively.

Financials "are generally cyclical [so] could be a play on an economic variable," says Robert Starkey, portfolio manager at Schroder Investment Solutions. "Growth investors could use value stocks as a hedge against rising rates if they can't get this via other assets. Various central banks are starting to move in different rate cycles and magnitudes so there could be a regional play."

 

Financial risks

McDermott says that investors could consider investing up to 5 per cent of their assets in a financials fund. It's best not to put too much of your portfolio into a single-sector fund because it is entirely focused on the risk of one area and cannot diversify away if there are problems.

Financial stocks can be very volatile and if banks, for example, lend too much they could face problems if the loans are not repaid, a problem that can be exacerbated in a recession. Some major economies are expected to enter into recession this year if they have not already. Further out, if interest rates come down a lot banks would not be able to make as much of a margin on their loans.

Other factors include how well-capitalised banks are. "Consumer and business health needs to be considered – defaults versus provisions, and levels of spending," adds Starkey. "If you [think] that value as a factor will do well you are likely to be exposed to financial services and banks.

A case can be made for banks in general, but this relies on the bank itself, the cycle of the central bank in the region, and the health of businesses and consumers. It might also be worth considering other cyclical opportunities or alternative financial services."

For this reason, a broad financials fund is probably a better option than an exchange traded fund (ETF) entirely invested in bank shares as it is not wholly reliant on the latter, and has more potential growth and dividend opportunities. Daniel Lockyer, senior fund manager at Hawksmoor Fund Managers, adds: "We haven't owned a financials fund for a while as we have viewed them as too reliant on a macro call – ie, what will happen to interest rates? Banks are in better shape than ever and valuations are attractive, but we have found other parts of the market much cheaper and easier [on which] to make a fundamental call on prospective returns."

If you do add a financials fund, make sure that you are not overexposed to the sector as your other investments might already provide significant exposure. "Investors are likely to have significant financials exposure already if they have a diversified portfolio, as the sector makes up over 20 per cent of the FTSE All-Share and over 10 per cent of the S&P 500 indices," cautions Ryan Hughes, head of investment partnerships at AJ Bell. "So anyone wanting specific exposure to the sector should be careful not to become overexposed to a single sector and may want to limit the size of a dedicated sector position in their portfolio."

 

Funds for exposure to financials

Because of its attractive PE ratio and dividend yield, you could consider a fund that tracks MSCI World Financials index. These strategies are also cheaper than active financials funds so their charges do not eat so much into your returns.

Options include Xtrackers MSCI World Financials UCITS ETF (XWFS), which has an ongoing charge of 0.25 per cent. It buys shares in the companies included in this index.

The ETF had over 60 per cent of its assets in North America at the end of November, with the rest mainly in developed countries. Banks accounted for about 43 per cent of its assets and insurance about 20 per cent.

Hughes highlights SPDR MSCI World Financials UCITS ETF (FNCW), which tracks the MSCI World Financials 35/20 Capped Index by mainly investing in companies included in it, and has tracked this index closely. The ETF held 225 companies which had, on average, a PE ratio of 12.2 per cent as of 6 January. The index had a dividend yield of 3.14 per cent.

Roughly two-fifths of the ETF's assets were in banks, with 24.4 per cent in insurance and 22.1 per cent in capital markets companies, as of 6 January. Some 62 per cent of its assets were in North America, with about 5 per cent in each of Australia and Japan, and most of the rest in Europe.

"The largest holding is Berkshire Hathaway (US:BRK.B), Warren Buffett's conglomerate [which accounted for 5.6 per cent of the ETF's assets as of 6 January]," says Hughes. "This ETF costs 0.3 per cent a year and yields over 3 per cent, which may make it appealing for income seekers as well as those wanting capital growth, as much of those additional profits have traditionally been paid out to investors in dividends."

However, an ETF tracking MSCI World Financials is likely to be exposed to high volatility as this index can swing from dramatic falls to meteoric rises from year to year – its 2021 and 2022 performance being a prime example.

For active exposure to financials, McDermott favours Polar Capital Global Insurance Fund (IE00B61MW553), which invests in 30-35 listed insurance companies. Although it is focused on one subsector, its managers, Nick Martin and Dominic Evans, aim to diversify the fund well within this area, changing its composition to invest in particular classes of business as premium rates, terms and conditions, and loss activity change. They seek to identify and allocate capital to companies that have more focused underwriting strategies, and whose managements have a meaningful ownership stake and are incentivised to grow book value per share and dividends. The fund’s investment team does its own research and places great importance on meeting managements on the basis that insurance is a promise to pay – so assessing their integrity is key.

The fund has a strong performance record against the MSCI World Insurance index and is defensive relative to the MSCI World index. For example, in 2022 it returned 24.4 per cent while the index fell 7.3 per cent. "Everything around us is insured, regardless of economic boom or bust, which provides this fund with very good defensive characteristics," says McDermott.

Polar Capital Global Insurance is well diversified across insurance subsectors, mainly in the non-life area, but largely focused on North America where it had 85 per cent of its assets at the end of November.

Jupiter Financial Opportunities Fund (GB00B5LG4657) invests in the shares of companies across all financial sectors globally with banks accounting for 47.7 per cent of its assets at the end of November, non-life insurance 18.7 per cent, and investment banking and brokerage services 12.8 per cent. It has a broader geographic distribution than MSCI World Financials index with 35.2 per cent of its assets in Europe ex UK, a third in North America and 13.4 per cent in Asia Pacific ex Japan at the end of November. The fund has underperformed the index in the past two calendar years but has often beaten it in other years over the past decade.

Its manager, Guy de Blonay, prefers businesses with sustainable growth characteristics and tries to identify them via a thematic approach, looking at the wider trends driving the economy and the impact these have on the financial services sector. Themes along which the fund invests include digitalisation, payment solutions, data analytics and security. De Blonay also likes stocks to have a reasonable valuation, and takes a view on whether this is the case according to factors including how strong a company's competitive advantage is, whether it is creating profits at a higher rate than it costs to generate capital, the sustainability of its business model, its products' growth prospects and ability of its management.

 

Performance (cumulative total returns)
Fund/benchmark1yr (%)3yr (%)5yr (%)10yr (%)Ongoing charge (%)
Artemis Income 2.5611.1222.61105.850.8*
GAM UK Equity Income3.1619.1925.18 0.64*
City of London Investment Trust share price9.5310.7721.36101.270.37**
Henderson High Income Trust share price0.317.3119.38105.420.84**
FTSE All Share Index2.9310.4518.9188.73 
IA UK Equity Income sector average0.356.5613.6286.42 
Jupiter Financial Opportunities-18.51-0.0921.18123.621*
Polar Capital Global Insurance***26.0737.7277.20314.030.83*
Polar Capital Global Financials Trust share price-8.6517.8827.42 1.02**
MSCI World/Financials Index-0.2923.7131.02169.63 
MSCI ACWI/Financials Index0.1819.5825.97146.35 
MSCI World Index-5.1525.4348.77207.27 
Source: FE Analytics, 9 January 2023, *fund providers, **AIC.
***The history of this unit/share class has been extended, at FE fundinfo's discretion, to give a sense of a longer track record of the fund as a whole.