It has been a tough start, with many of the biggest US, UK and European banks reporting downbeat earnings for the first quarter. They include single-digit returns on equity from once-vaunted Goldman Sachs, the slimmest capital buffers from Germany’s Deutsche Bank, and unfinished asset purges from the Royal Bank of Scotland and Barclays — confirming why investors in anything but financial services would have been better off over the past one, three and 10 years.

The headwinds for the sector remain daunting: fragile global growth, negative interest rates in Europe and Japan, fears of China’s leverage, and no letting up in regulation.

Yet, there are pockets of green shoots. Net interest margins in the US are increasing a touch after years of decline. Oil prices are off year lows and holding above US$40, calming default fears. Eurozone GDP levels finally returned to pre-crisis levels. With some bank shares currently trading at deep discounts to tangible book value, a reappraisal of the sector could lead to a potentially sharp rally.

Indeed, energy and the MSCI World Financials Index have rebounded strongly from February lows. The latter’s 13.1% rise (in Singapore dollar terms) has outpaced the all-sector World Index’s 9.7% gain.

Funds fill the financial services bucket in diverse ways
Investors looking to invest in the seven Sector Equity Financial Services funds sold in Singapore (there are 68 globally) may find it useful to know that each offers different geographical and subsector exposures. With 23 developed markets and as many emerging markets in commonly tracked financials benchmarks, funds have exploited the extensive universe in financials with varying degrees of success. This is seen in returns that range from -6.1% to -26.5% over the past year, according to Morningstar Direct.

The NN (L) Banking & Insurance fund, a 19-year-old fund managed by the investment arm of Dutch insurer NN Group, registered the most resilient one-year performance. Losses were capped to nearly half of the 11.6% fall in the MSCI World Financials Index.

The fund’s decision to underweight banks and life insurers, and favour property and casualty insurance, asset managers and real estate investment trusts, was key. Banks make up only 36% of NN (L) Banking’s $118 million portfolio, compared with 42% in the MSCI World Financials Index.

NN (L) Banking kept exposure to the UK and periphery European banks low, and sought niche players such as regional and custody banks to lift returns.

“Stock selection within banks was positive, where our holdings in Canadian bank Canadian Imperial Bank of Commerce and Israeli Bank Hapoalim contributed [to performance]. Swiss asset management firm Partners Group was the strongest performer on a stock level,” says Pieter Schop, senior portfolio manager of Optimised Portfolio Strategies at NN (L) Investment Partners.

Faced with a straitjacketed landscape of low interest rates worldwide, the Fidelity Global Financial Services fund’s strategy has been to underweight banks (33% is the lowest of the seven funds) and insurance, while making room for exceptions and selective opportunities. Like NN (L) Banking, Fidelity has limited its exposure to European and Japanese banks. Portfolio manager Sotiris Boutsis flags German property as the fund’s most successful theme this past year. Benefitting from low yields, its holdings include Deutsche Wohnen, up 21.2%; and Grand City Properties, up 20.5%.

This approach helped insulate the largest fund with $1.1 billion of assets from severe losses, earning it a top-quartile position over one year in its category worldwide. Year-todate, however, the fund has lost some ground. Its 5.2% exposure to China would have been a drag with Industrial & Commercial Bank of China, the country’s biggest lender, down 16.7%. Boutsis recently realised profits and trimmed his Chinese real estate position, while maintaining pan-Asian life insurer AIA Group — a reflection of his appetite to take on beta when convinced of the longer-term potential.

The underperformers
Conversely, financials funds that bet big on banks, capital-market-reliant financials and Europe suffered over the past year. Among them were the $467 million BGF World Financials fund, down 17.3%; and the $195 million JPMorgan Global Financials fund, down 13.6%. Both funds had over 55% invested in banks.

Among the worst performers in BGF World’s top holdings over one year were US private equity firm KKR & Co, down 39.4%; asset manager Affiliated Managers Group, down 25.5%; and French bank Société Générale, down 23.1%.

Meanwhile, JPMorgan Global’s top holdings that performed the worst in the past year include British bank Barclays, down 36.7%; US capital markets firm Morgan Stanley, down 27.2%; and custodian bank State Street, down 20.2%.

Home-grown UOB Asset Management offers two starkly contrasting financial sector funds. The United Asia Financials fund, which is highly exposed to China, was the worst performer over the past year, losing over a quarter of its value. It is mandated to invest within Asia (excluding Japan) and currently invests 30.4% in China, 22.4% in Hong Kong and 11.6% in Singapore. The latter two countries count China as a major trading partner.

The fund’s China positions that suffered over one year include Industrial and Commercial Bank of China, down 38.1%; stock exchange operator Hong Kong Exchanges & Clearing, down 35.7%; and Chinese insurer Ping An Insurance Group, down 34.6%. With just $3 million under management, United Asia has an expense ratio of 2.87%, while other financial services funds charge less than the 2% average for retail funds in Singapore.

In contrast, the $35 million United Global Financials fund has no exposure to China and turned in the best performance this year, down only 5.8%. Pursuing a more global footprint, the fund favours financials in the US where banking is healthiest and the high-growth Asian emerging markets of India and Indonesia.

John Doyle, chief investment officer of equities and multi-asset at UOB Asset Management, sees attractive prospects in the latter on the back of relatively low levels of household and corporate debt. “As banks in emerging markets typically have high risk-adjusted margins compared with banks in developed countries, their medium-term growth prospects and valuations are also more attractive,” he says.

United Global has single-digit exposure to insurance, and its highest allocation of 27% is in asset management and credit services companies. They include the two dominant global payment systems providers, VISA and MasterCard, which are up 19.1% and 7.3% respectively in the last year. “We believe that there is potential for growth in payment processing services, given the increasing number of companies transitioning from cash to electronic payments,” says Doyle.

This article appeared in the Personal Wealth of Issue 728 (May 16) of The Edge Singapore.