One of the great rules of investing is don’t buy something that you don’t understand. Fortunately, most businesses are reasonably straightforward, but one sector that is riddled with complexity is financials, especially when it comes to the banks, insurance and life assurance companies that make up the majority of it.
Unfortunately, financials are also the second-largest sector in global equity indices (based on the MSCI All Country World Index, a neutral weighting in the sector would be more than 16% of your portfolio), so it isn’t something that can be ignored.
In addition, if you restricted yourself to investing in UK financials, just 10 stocks account for over 90% of the market cap of the MSCI UK Financials index and HSBC accounts for well over a third of that.
There is a clear need to diversify your exposure, but that makes the stock selection decision even harder. Therefore, there is an excellent case for accessing the sector through a globally diversified fund managed by an expert team.
In the investment companies world, two trusts are focused on this sector – Polar Capital Global Financials trust and Augmentum Fintech. However, they target very different parts of it; the Polar trust is designed to offer broad-based exposure, while Augmentum is focused on the hopefully fast-growing new entrants to the industry, many of which are still unquoted companies.
Augmentum’s approach comes with considerable additional share price volatility. In net asset value (NAV) terms, it has made money for investors, but it currently trades on a discount of more than 37%. That discount could close and the NAV could continue to climb as more of its holdings exit to initial public offerings (IPOs) or trade sales, but this is probably not the fund in which you would choose to put a significant proportion of your portfolio.
Polar Capital Global Financials was listed in July 2013. Part of the pitch was that the outlook for the UK financials sector looked pretty dire and this was a way of globalising your exposure. It was designed to be a trust to which an investor could entrust all their financials exposure.
From its launch up to end May 2024, the trust has generated a 154% return on its NAV. An investment in the best of the UK banks – HSBC – made around half that. Buying Barclays would have made hardly any money at all.
The managers at Polar Capital see plenty of reasons why the trust might do well from here. They have picked out five themes that they think will help the trust beat its benchmark.
The first of these is backing asset managers that specialise in alternative asset classes such as private equity, infrastructure and credit. These companies are managing a growing proportion of investors’ funds and that trend is forecast to continue for some years yet. The profit margins that these businesses earn is attractive, often incorporating performance fees. The best of them are also consolidating a highly fragmented market.
Next is reinsurance companies. A series of natural disasters have eaten into the capital that is made available to reinsure risks. That in turn helps drive up the cost of reinsurance and the profit potential of these companies. An environment of higher interest rates has also helped these businesses earn much higher returns on their capital base.
Given its worldwide remit, Polar Capital Global Financials is able to take advantage of the superior growth potential of financials operating in emerging markets. The managers are selective about which companies and in what markets, but the earnings growth achievable from selling financial products into often previously untapped markets is considerable. Polar Capital is also looking to profit from corporate governance reforms in Korea that are designed to boost returns to investors.
The managers have spotted a growing opportunity in smaller and medium-sized financial companies which have been left behind recently and are looking cheaper than usual. The large caps in the sector have noticed this too and mergers and acquisitions activity is picking up.
That also feeds through into the revenues for investment banks. The trust’s managers are being selective about which banks they back. On average, valuations look attractive, but some banks are more fully valued than they were, and others (especially smaller US regional banks) have exposure to possible problem areas, such as loans secured against office space. They are optimistic about investment banking revenues, however, and so this is reflected in the portfolio.
Currently, you could buy shares in Polar Capital Global Financials on an 8% discount to NAV. However, it operates with a liquidity opportunity that in 2025 and every five years thereafter lets you cash in shares at a price close to NAV. That suggests that the discount will narrow from here.
James Carthew is head of investment companies at QuotedData. The views expressed above should not be taken as investment advice.