Could rising rates finally see the stars align for specialist financial funds?

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06 December 2021

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The outlook for financial funds between the start of the pandemic and now is like chalk and cheese.

In April 2020, weeks into the Covid-19 market sell-off, almost 40% of shares in the Polar Capital Global Financials Trust were redeemed via a tender offer amid a dovish outlook for rates and enforced cancellation of dividends. It was left with just £100m in assets under management. That summer, Jupiter announced it was rebranding Guy de Blonay’s unit trust and ditching performance fees after two years of near constant outflows.

But shareholders that remained in the Polar Capital trust have earned 96.3% since the tender offer, compared with 38.7% in the FTSE All-Share, according to FE Fundinfo. And Jupiter Global Financial Innovation, which was deemed a hard sell amid loose monetary policy and cancelled dividends, has returned investors 37.8% since its August rebrand, versus 27% in the FTSE All Share over the same period.

The MSCI ACWI Financials Index fell 34% at the start of the pandemic but has returned 75.9% since.

Wise Funds manager Philip Matthews tapped into the Polar Capital Global Financials Trust in September 2020, at a point when the net asset value was “extremely depressed”, plus it was trading on a 10% discount. It currently represents 2.2% in the TB Wise Multi-Asset Income Fund, which Matthews runs alongside Vincent Ropers.

“We continue to believe financials is a sector best positioned to benefit from the gradual recovery of the global economy post-Covid, and any increase in inflation that causes interest rates to rise should prove a powerful tailwind for earnings,” Matthews says.

‘The story has obviously changed in the past year’

Rhetoric from the US Federal Reserve and Bank of England became markedly more hawkish towards the end of summer 2021 and, in September, 12 central banks raised interest rates – the largest number of banks in a single month in just over a decade, according to Polar Capital.

“The story has obviously changed in the past year,” according to Polar Capital Global Financials Trust manager Nick Brind (pictured), who co-manages the portfolio with John Yakas and George Barrow. “The investment trust has been issuing shares, including a £120m C-share offer, to meet investor demand, and total assets have increased to £475m today.

“Owning financials does provide a degree of insurance policy against higher inflation and interest rates,” says Brind. “A 1% increase in interest rates for US banks will probably add high-teens to their earnings, rising to over 20% in year two. For some European banks we’re looking closer to 25% in year one.”

The successful Pfizer-Biontech vaccine trial was what triggered the turnaround in investor appetite for the Polar Capital Global Financials Trust, which is one of only two products in the AIC Financials sector, alongside EJF Investments. Since the start of the pandemic, the investment trust had been trading at a 5-10% discount to net asset value but, by December 2020, it was trading at a small premium.

Wise Funds, which holds UK banks directly in its income portfolio, benefited from the investment trust being able to tap into its reserves as regulators forced banks to cut dividends.

“By selling a number of our direct holdings and reinvesting into the trust, we were able to maintain the significant capital upside opportunity, enjoy a 4% dividend yield at that time and access similar exposure at a 10% discount,” says Matthews.

The investment trust was the top-performing financial fund in the 12 months following the Pfizer announcement, delivering shareholders 45.2%, although gearing and the switch to a premium supercharged returns, with the net asset value rising 34%. Gearing touched 12.2% in February but currently sits at 7.1%.

The Jupiter Global Financial Innovation Fund, managed by Guy de Blonay, returned 37.9% over the same period, while the MSCI ACWI Financials Index returned 35.2%.

Tap into fintech innovators or stick with banks?

Where Jupiter Global Innovation has been able to deliver better performance than the Polar Capital Global Financials Trust on an net asset value (NAV) basis is through its exposure to the fintech names that benefited from the rise of e-commerce and online payments during coronavirus lockdowns.

Paypal is the fund’s second-largest holding, at 4.5%, followed by cloud communications business Twilio. Signature Bank, founded in 2001, is the closest the top-10 holdings come to a traditional bank.

De Blonay says adding fintech to his investment universe enables the fund to perform in different market environments. “Some sub-segments will benefit from higher market volatility or interest rates, while others from an opposite environment.” De Blonay has been increasing exposure to banks and insurance stocks over the past 12 months, citing their surplus capital, high levels of impairments reserves, plus higher inflation and interest rates on the horizon.

But he favours companies that have been investing heavily in technology, saying some banks have become complacent in the digital arms race. “Those banks are losing market share and revenue opportunities to new, more innovative players.”

Polar Capital Global Financials is happy to stick by its focus on traditional financials, says Brind. It currently has around 6% in fintech but that reached 15% in the middle of 2021. “We’re trying to provide a broad exposure to global financials, and banks represent between 40% and 50% of the sector.

“There are undoubtedly great opportunities in fintech, but if you’re an asset allocator and you’re investing in a tech fund, a fintech fund and then an AI fund, you’re not getting much diversification.”

Data from the past three years proves his point. Polar Capital Global Financials has a low correlation with the FTSE All World Technology Index with a correlation coefficient of 0.54, while Jupiter Global Financial Innovation has a positive correlation of 0.82, according to FE Fundinfo. Brind’s fund also has a stronger negative correlation with US 10-year treasuries, with a correlation coefficient of -0.33 compared with -0.16 in De Blonay’s fund.

The benefits of fixed income for financials exposure

A fund that is even more negatively correlated to US treasuries, with a correlation coefficient of -0.41, is Gam Star Credit Opportunities, a fixed-income strategy sub-advised by Atlanticomnium, which accesses legacy corporate debt of mostly investment-grade financial companies. During the 2013 taper tantrum, the fund was up 6.2% versus a 2.9% fall in the Barclays UK Agg Corporate Index, according to Gam Investments.

The fund’s interest rate sensitivity is dampened, not just the financial names it holds but also due to relatively low duration of the bonds it invests in, explains fund manager Patrick Smouha, who co-manages the fund with his father Anthony Smouha and Gregoire Mivelaz. “People think about perpetual bonds when they think of subordinated debt, but most bonds in this strategy are actually issued with call dates. They’re what we call fixed-to-floaters,” says Smouha.

He points to HSBC as an example, stating it will issue a perpetual bill with a call date within five years. “If it’s not called in five years, the interest rate will reset at that period at a certain spread above government bond rates, and that means your duration is always below five.”

Smart Investment Management has held Gam Star Credit Opportunities in its portfolios for over seven years and it currently accounts for a 5.5% weighting in its VT Smartfunds Cautious Portfolio, 4.4% in its Balanced strategy and 3.8% in the Growth portfolio.

Fund manager Nick Stanhope likes the strong yields it delivers from investment-grade issuers, relatively low default risk and protection against rising rates. “Within the portfolios, the Gam fund has a higher correlation to equity than government bonds and in a ‘normal’ risk-off environment, it typically sells off,” he says. “However, if market sell-offs are triggered by concerns over higher rates, the fund has historically been defensive. The spread cushion on offer today is tighter than when we first invested, and likewise the yields are lower.”

The team is in the process of swapping the fund for the Sanlam Hybrid Capital Bond, which historically has had lower exposure to Additional Tier 1 bonds, which means a lower drawdown when sell-offs have been triggered by fears of recession.

Looking beyond banks and financial funds

Elsewhere, Smart Investment Management also has exposure to financials via the Polar Capital Global Insurance Fund. Says Stanhope: “Prior to the pandemic this was held as a defensive equity fund, as typically in an economic downturn, businesses still buy insurance and therefore it is relatively less impacted by downturns.

“However, it was anything but defensive during the pandemic and we now consider it as a value fund within our portfolios, benefiting from a stronger pricing environment. In the short-term, markets tend to price it in line with the banking sector, and it has been performing better when the yield curve has been steepening.”

Wise Funds points to its allocations to value funds as another area where it gains exposure to banks and financials, with Matthews noting their holdings in Man GLG Undervalued Assets, the Temple Bar Investment Trust, Middlefield Canadian Income, JO Hambro UK Equity Income and the Lightman European Fund as notable examples.

However, not all equity managers are taken with banks. Aviva Investors UK Listed Equity Income Fund co-manager James Balfour says although the fund is overweight financials as a whole, banks have become regulated utilities with higher returns available elsewhere across the financial sector.

“The likelihood is that banks will likely outperform in the short run over alternative financials, if there is a sharp and persistent move in the curve,” Balfour says. But over the medium term he sees better opportunities in insurance. “Like we saw in 2016, post the Brexit referendum result, there was confidence in the market on rising rates and the likes of HSBC did see a short-term share price benefit, though the impact was more limited to the short term as the rates environment stalled out. On the whole, alternative financials saw a more gradual but continued recovery.”

Intermediate Capital, Phoenix and Legal & General are among the fund’s largest overweights as the team attempts to tap into themes such as consolidation of wealth, pension management and hardening rate markets in insurance via alternative financials. Says Balfour: “There is clearly some exposure to rates in all the names, but we fundamentally believe in the factors driving the businesses and therefore the movement in the rates market will not be a determining factor in driving a return.”