Financials-Heavy Funds Make a Comeback

One year ago, it seemed as though our entire financial system was in danger of unraveling. Fear was already in the air after more than a year of increasingly serious fallout from the mortgage crisis, but things got much worse in September 2008. Within a span of two weeks, mortgage giants  Fannie Mae (FNM) and  Freddie Mac (FRE) were effectively taken over by the federal government, Lehman Brothers filed for bankruptcy, Merrill Lynch was bought by  Bank of America (BAC) to keep it from going bankrupt, and the government bailed out insurance giant  AIG (AIG) with an $80 billion loan guarantee. All this, but especially the collapse of Lehman on September 15, caused credit markets to freeze, the recession to deepen, and the stock market to plunge dramatically.

Of course, we now know that things didn't completely fall apart, but it was still a time of huge uncertainty, and the stock market didn't hit bottom for another six months. When this crisis was unfolding back in September 2008, we took a look at the mutual funds with the biggest stakes in the financials stocks at the heart of the storm. These included funds with big stakes in Fannie and Freddie, and those with big stakes in Lehman, AIG, and Merrill Lynch and other big banks. Not surprisingly, most of these funds got hammered in 2008. We also took a look at funds that avoided the most troubled financials, and found that many of these funds (though not all) held up relatively well amid the market carnage.

A year later, things look very different. The U.S. economy, while still not in great shape, appears to be on the mend, and the stock market has risen dramatically since March 2009. Among the biggest gainers have been stocks that got hit hardest in last fall's meltdown. Fannie Mae, Freddie Mac, and AIG are all up more than 400% off their March lows, and many other beaten-up financials have posted huge gains.

We decided to see how this shift has affected mutual funds with big holdings in financial stocks. We focused on diversified domestic-stock funds, meaning those in the nine Morningstar Style Box categories, and further restricted the list to actively managed funds with at least $100 million in assets. Within those parameters, the following table shows the 10 funds with the highest percentage of financial stocks in their most recent portfolio. In addition to that percentage, we show each fund's category, the size of its asset base, its percentile ranking within its category over the past six months as of Sept. 14 (roughly since the rally began), and its percentile ranking in 2008.

Diversified Funds with the Most Financials

 
Not surprisingly, these funds have done pretty well in the six months since the rally started. All 10 of these funds have gained more than 50% over the past six months, led by Snow Capital Opportunity's (SNOAX) 107% gain; eight of the 10 have beaten their category over that time, and five are in or very near the top decile. In contrast, the same group mostly had a tough time in 2008, with half of the funds ranking in or near their category's bottom decile, and nine of them losing more than 30%. These are mostly value funds or value-leaning core funds, which is not surprising given that financials are traditionally value stocks, and many are now especially cheap by most traditional measures.  Clipper (CFIMX) is a good example. Managers Chris Davis and Ken Feinberg have maintained a large financials weighting ever since taking over the fund at the beginning of 2006, a strategy that hurt them badly in 2008 but helped during the recent rally.

Three of the funds that don't fit this pattern very well-- Goldman Sachs Small Cap Value (GSSMX),  Fidelity Advisor Small Cap Value (FCVAX), and Principal SmallCap Value I --are all in the small-value category. That's no coincidence. Many small-cap banks and other small-cap financial stocks held up in 2008 much better than big banks that were hurt by mortgage exposure and complex derivatives, but that also means that they haven't bounced back nearly as much this year, and some have been hit recently by expanding credit problems. A good example is First Financial Bankshares (FFIN), a top-five holding of Goldman Sachs Small Cap Value; it gained 50% in 2008 but is down 8.8% so far in 2009.

What about the opposite group--funds with the lowest percentage of financials in their portfolio? Using the same criteria as above (diversified, actively managed funds with at least $100 million in assets), there are 11 funds with no financial stocks at all in their most recent portfolio. The following table shows the 10 largest of these by assets, including the same data points as in the first table.

Diversified Funds with No Financials

 
Not surprisingly, the results here are basically the inverse of what we saw in the first table. Despite substantial absolute losses, nearly all of these funds beat their category in 2008, with six ranking in the top decile. And while they've gained ground over the past six months, like nearly all stock funds, they've badly lagged their peers; six of the funds, including the five largest, rank in their category's bottom decile over that period. Most of these funds focus on quality blue-chip stocks with stable earnings and not a lot of leverage--a group that includes few financials after the upheavals of the past couple of years. That strategy hasn't worked too well in the current risk-fueled market, but it has generally worked pretty well over time. Of the funds on this list,  Royce Special Equity (RYSEX) is a Fund Analyst Pick in the small-value category, and  Amana Growth (AMAGX),  Chase Growth (CHASX), and  Brown Capital Management Small-Cap Growth I (BCSIX) all sport 10-year returns in their category's top decile.

That's not to say that there aren't also good funds among those owning a lot of financials--that group also includes an Analyst Pick (Clipper) and several funds with solid long-term records. Owning a lot of financials isn't inherently good or bad, but it can have a significant effect on fund performance in the short term, with the past two years being extreme examples. Some of the financials-heavy funds look for cheap stocks first and foremost, but this can be a risky short-term strategy when things are cheap for good reasons. That's why it's always a good idea to be aware of the relative sector weightings in any fund you own, and to make sure you're comfortable with any big overweights or underweights relative to the category average.

Lehman: One Year Later
As the market recovers from the Wall Street titan's failure and a chilling credit crisis, PIMCO's El-Erian, TCW's Gundlach, Morningstar analysts, and others chart the landscape, risks, and opportunities for investors today.