After months of speculation, the Bank of England finally raised interest rates on 2 August. With rates so low for so long, banks have seen their margins squeezed but, with interest rates now rising, will profitability improve and if so, could specialist financials funds be worth considering?

UK banks are still paying off the excesses of the years preceding the financial crisis, with vast sums set aside to cover PPI claims, litigation costs and writedowns, but these liabilities should now be nearing their end.

The Big Five FTSE 100 banks reported £9.3bn in pre-tax profit in Q2 2018, their best three-month showing in five years.

Barclays (BARC) and Lloyds (LLOY) both raised their interim dividends, while Royal Bank of Scotland (RBS) and Standard Chartered (STAN) resumed first-half dividend payments, putting them on track for their largest combined payout since 2007. However, these encouraging signs are not yet being reflected in share prices.

BACK TO BANKING

Ryan Hughes, head of active portfolios at AJ Bell, says banks have not been a great place to be invested, but the focus is now back on the day job. 

‘Banking is and should be the most simple business in the world: you lend money at one rate, you pay depositors another and you earn the margin between the two.

‘Banks have got back to doing that and, as rates go up, the amount they can earn on that differential increases too so we should see an increase in profitability and an interesting opportunity for investors.’

He added UK banks are showing a commitment to pass those increases on to investors as dividends, and this should be rewarded in share price performance.

THE LINK WITH RATES

However, the relationship between interest rates and banks’ bottom lines is not a one-for-one correlation, notes Mike Coop, head of multi-asset portfolio management at Morningstar.

‘This link with interest rates is not stable and is not a reliable way of assessing what is going to happen,’ he says, pointing to other factors like the interest they pay on their own funding sources, the quantity of money they can lend, and the amount of bad debt on their books.

He points out that income for European and UK banks has actually risen since 2013, even though interest rates came down over that period and stayed low. This is because banks were able to reduce their costs and the interest they paid on their loans.

His view is that relative valuation based on sustainable earnings is a more reliable guide to bank performance than the direction of rates. On this metric, banks look better value than expensive global equities at the moment, says Coop, although he warns they are ‘not cheap and are inherently risky’.

ACTIVE FUND PICKS

There is more to the financial sector than just the big banks. It incorporates a wide spectrum including general insurers, reinsurers, asset managers and sub-prime lenders.

Hughes explains that some of insurers’ profitability comes from what they earn on their cash balances, so they could look attractive in a rising interest rate environment. He suggests Polar Capital Global Insurance (B530JS2) as a specialist fund which should benefit from this trend.

Financials make up a large part of the UK stock market, around 20%. Any investor who owns a FTSE All Share tracker or an active UK equity fund is likely to already have reasonable exposure. In the US, around 14% of the S&P 500 is in financials, but it is made up of more investment banks than retail banks.

If you want more exposure, a handful of active funds exist with long track records, headed by experienced managers. Hughes highlights Jupiter International Financials (B58D9P3), managed by Guy de Blonay, and Janus Henderson Global Financials (3191923), which had a manager change last year.

Morningstar fund analyst Samuel Meakin points to the much larger Fidelity Global Financial Services (BJVDYZ3) fund, run by Sotiris Boutsis. Because the manager invests in quality financial stocks, the fund is more likely to outperform in a falling market, he says.

In the closed-ended space, one option is the Polar Capital Global Financials (PCFT) investment trust, which has around 64% in global banks and 11% in insurers.

Meakin adds: ‘If you are looking to invest in specialist financials funds, given you are taking on the style risk of the manager, you want to hold them as long-term holdings for at least three to five years.’

A PASSIVE APPROACH

All three fund experts say passive products like exchange-traded funds are a good starting point for investors interested in financial stocks.

Hughes says investors should think about why they are going into the sector, how long they plan to keep their exposure, and whether an active manager can do well enough over that time to justify their fees.

‘There is not a huge amount of evidence of [active manager] skill and alpha that is consistent over time so I think that would push me towards simply taking the passive option and buying pure exposure to either banks or financials.’ He points to the Lxyor MSCI World Financials ETF (FINW), which at 30 basis points is low cost and tracks a broad-based index so it is well diversified.

‘It is a good 40-50 basis points cheaper than any active strategy so the active managers would have to work very hard to outperform that.’

Coop agrees, noting that investors’ go-to product type for exposure to a compelling part of the market should be through a cheap ETF as a starting point, before they decide whether it’s worth paying for active management.

‘There’s no one size fits all, but the cost of more specialised exposure particularly for retail investors means you want to be thinking twice. At the moment we don’t think the opportunities are attractive enough to go down that route.’ (HS)

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