January 6, 2012

3 Funds to Consider if You Think Financials Are Due to Rebound

It would be hard to overestimate the importance of economic growth to investors. While there are, of course, “defensive” companies that perform relatively well during periods of stagnation or recession, a rising tide lifts all boats and an ebbing tide—well, we all saw what happened in the first three months of 2009. 

During the Great Recession and its uninspiring aftermath, no sector of the economy has taken more of a hit than financials. From the start of 2008 to the market low on March 9, 2009, financial stocks of the S&P 500 delivered investors a decline of about 74%, compared with a 50% drop in the broad market index. Since then, they have posted a 94% total return, vs. about 75% for the S&P 500. Both financials and the “500” are currently trading at about the same level they frequented in mid-2008, but obviously it has been a wilder ride for financials. 

 

This type of volatility scared many investors away from financial stocks and at least partially accounts for the sector’s dismally low valuation: 9.5 times estimated 2011 earnings, the lowest of the S&P 500’s 10 sectors, according to estimates by S&P Capital IQ.

However, for those who are beginning to sense theU.S.economy is gaining strength, financials may be worth some investigation. With important economic indicators like consumer confidence, durable goods orders, industrial production, new home sales and now even employment showing signs of steady improvement, financials stand to benefit greatly, in our view, if the economy begins a more rapid expansion. 

The Basel III Effect
While financials have always been cyclical, they are even more so now due to the Basel III regulations coming into effect in coming years, which could force some of the largest financial institutions to raise their capital holdings by a significant amount. This would be difficult to do even under advantageous conditions, and any slowdown in the economy would make these new requirements extremely hard to meet without selling new equity. On the other hand, a stronger economy would make the task comparatively easier. 

“With Basel III coming up quickly, banks have little or no leeway in terms of economic growth and capital levels, thus their wild swings in response to good and bad economic news,” says Eric Oja, an S&P Capital IQ equity analyst.  

On the first trading day of 2012, S&P Capital IQ’s Investment Policy Committee raised its recommendation for the financials sector to marketweight from underweight, in part due to its
belief that recent steps by the European Central Bank to infuse fresh capital into European banks have reduced the odds of a near-term credit crunch emanating fromEurope. (S&P Capital IQ had an underweight recommendation on financials since May 17, 2011.) In particular, S&P Capital IQ analysts have a positive fundamental view of the consumer finance as well as the investment banking and brokerage subsectors. 

Three Funds to Consider
To uncover attractive mutual funds focused on the financial sector, we screened for those with S&P’s

highest five star rank that are open to new investors and not intended for institutional customers. (It is important to note that S&P Capital IQ looks not only at past performance, but also analyzes underlying holdings, risks and costs when determining a star ranking for mutual funds.) Of the 25 distinctU.S.mutual funds targeting financials, just three met those criteria. 

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The Davis Financial Fund (RPFGX) has the strongest three-year return of all financial sector mutual funds, and places in the top five for one- and five-year returns as well. Since it opened in May 1991, the fund has delivered an average 10.93% total return, compared with a peer average of just 1.56% over the same period. What really stands out about this fund, however, is its portfolio turnover of just 2%; about half the names in its top-ten holdings as of Sept. 30, 2011, were in the portfolio four years previously. The fund is fairly concentrated, with its top three holdings accounting for almost 30% of portfolio assets. 

The Legg Mason Investment Counsel Financial Services Fund (SBFAX) has a top quartile performance ranking among financial sector funds for the past one- and five-year periods. It invests in smaller financial sector stocks, with almost 60% of its assets in companies that have less than $3 billion in market capitalization. Like theDavis fund, its turnover is low, at 18% annually. It is more diversified, owning 49 different names compared with 32 for theDavis fund, and it had an attractive dividend yield of 3.64% as of November 30, compared with a peer average of 2.64%. While its management fee is higher than that of the other two funds, it is still below the peer average of 1.78%. The fund is smaller, with about $48 million in assets compared with about $460 million for theDavis fund. 

The Fidelity Select Insurance Portfolio (FSPCX)has a lower management fee than the others and is the only one that doesn’t charge a sales load. It has posted top quartile one- and three-year returns, and is middling in size, with about $250 million in assets. However, it is focused on the insurance industry only, and is not a broad-based financial services fund like the other two.

Another option for those investors looking for an inexpensive way to gain exposure to the financial sector is an exchange-traded fund, the Financial Select Sector SPDR (XLF). It has an overweight ETF ranking from S&P Capital IQ and is intended to track the performance of the S&P 500 financial sector. It pays a lower dividend, yielding 1.73% as of January 5, 2012, but is highly liquid, with average trading volume of almost one million shares daily. It owns 81 different names, yet its top three holdings account for more than 26% of its assets.

S&P Capital IQ Senior Editorial Manager Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for mutual fund and exchange traded fund stories.

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