One of the UK’s behemoth funds has made a bet on a recovery in European banking stocks, which its management thinks will rebound after the results of stress tests by policymakers.
The £21.6bn Standard Life Investments Global Absolute Return Strategies (Gars) team bought a basket of European banking stocks in September.
The move came after a sell-off in the sector but before the European Central Bank’s (ECB) Asset Quality Review (AQR) and stress tests, which analysed the quality of assets on bank balance sheets.
The results of the ECB’s review showed 25 European banks had failed to pass the test, though the figure, and the amount of bad debt on bank balance sheets, was better than some had expected.
The Gars team’s trade involves buying a basket of banking stocks and balancing out the position by taking an equal short position on the broader European equity index.
This means the Gars fund will make money if the banking sector outperforms the rest of the European equity market, regardless of whether the market itself moves up or down.
Roger Sadewsky, an investment director in SLI’s multi-asset team, said while there were question marks about European growth and the prospect of deflation, “banks look very cheap”.
He said the problems faced by the banking sector had already caused the companies’ share prices to be “heavily, heavily discounted” by the market.
According to data from FE Analytics, the MSCI Europe Banks index has plunged by 17.4 per cent in the past five years while the broader MSCI Europe index has risen by 29.1 per cent.
The sector has recovered in the past three years, since the end of the eurozone crisis, but sold off again over the summer, shedding more than 10 per cent between June and August.
Mr Sadewsky acknowledged the position was likely to be “volatile” because banks are still “under immense pressure” but claimed that, on a long-term view, the current value was too good to turn down.
He predicted “very healthy upside returns” from the position in the long term, though he acknowledged the chance that the team “could be a little early” in adopting the position and there was the potential for the sector to fall further in the short term.
The managers have also reduced the fund’s exposure to UK and European investment grade corporate bonds, taking the view that valuations had become “slightly less attractive” following a rally in the asset class.
Mr Sadewsky said investors were perhaps suffering from a bit of “complacency” in investment grade debt and warned that when the market focuses on interest rate rises, the assets most at risk will be the ones that have seen the most inflows, such as investment grade bonds.
The Gars team has introduced another trade that would generate returns when the US raises its base interest rate, in spite of the growing market attitude that anticipates the US Federal Reserve will not now raise its rate for a considerable period of time.
The new strategy is one in which the team has established a position to be short US forward duration.
Mr Sadewsky said this position would be “extremely rewarding” to the fund if the market became “concerned about future hikes in rates”, though he acknowledged that the market had recently gone through the opposite view, which had hurt the fund in terms of performance.
However, the other strategies within the portfolio combined to allow the fund to comfortably outperform both the IMA Targeted Absolute Return sector and its six-month Libor benchmark with a 2.9 per cent return in the quarter. The fund was hit by the flight to safety in markets in early October but is still ahead of its benchmark and sector so far this year, according to data from FE Analytics.
