Fund investments in bank stocks key to performance

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BOSTON (AP) — There are plenty of reasons to worry when it comes to investing in big banks.

Investors are still gun-shy three years after the subprime mortgage crisis and credit crunch triggered the Lehman Brothers collapse and taxpayer bailouts for other banks.

Yet despite that checkered past, the risks mutual fund investors face often go unnoticed, except by those who periodically check the latest disclosures about what stocks are in their funds.

If you’re not willing to do that, here’s a shortcut that could indicate whether further investigation is warranted: Review a fund’s year-to-date performance. If a diversified stock fund is badly lagging, there’s a decent chance the manager made big investments in bank stocks. If so, check the fund’s holdings online, or review any recent mailings you’ve received and consider if the risks seem appropriate for you.

One prominent fund recently held three-quarters of its portfolio in financial stocks, and it has lost more than 30 percent this year. That’s much steeper than the nearly 6 percent loss, including dividends, for the Standard & Poor’s 500 stock index. An index of large bank stocks is down 33 percent. And mutual funds that specialize in financial sector stocks are the worst performers among Morningstar’s domestic stock fund categories, with an average loss of nearly 22 percent.

Those numbers reflect investors’ current grim assessment of large banks. Many fund managers are reluctant to invest because the risks are so hard to calculate.

“No matter how smart a fund manager is, there will be a lot of unknowns now investing in banks,” says Harry Milling, a Morningstar analyst who tracks funds specializing in financial stocks. Fund managers he interviews often talk about the inability to know the risks.

A key concern is the complexity of bank balance sheets. They don’t capture the entire story about the potential for losses if other banks here and in debt-burdened Europe run into trouble and fail to meet financial obligations.

Then there are the remaining legal liabilities from the role of banks in the mortgage crisis; the ongoing flood of foreclosures; and new regulations requiring banks to hold bigger cash cushions to protect themselves against unexpected losses.

Those uncertainties come as persistently low interest rates make it difficult for banks to earn much from deposits.

On Wednesday, Moody’s Investors Service lowered debt ratings for Bank of America, Citigroup and Wells Fargo. The ratings agency said it has become less likely that the U.S. government would step in and prevent the three lenders from failing in a crisis.

Yet there are bold investors willing to accept those risks. Warren Buffett’s company, Berkshire Hathaway, invested $5 billion last month in Bank of America, whose stock has lost more than half its value this year.

Then there’s Bruce Berkowitz, manager of Fairholme Fund. Berkowitz’ past success investing in financial companies is a key reason why Morningstar named him Stock Fund Manager of the Decade in January 2010. The fund delivered market-beating returns averaging 13 percent a year during that time. However, Fairholme is the recent big loser that had a 75 percent stake in financial services as of May 31, according to Morningstar.

Fairholme (FAIRX) only holds about two dozen stocks, and its concentration in financials is nearly four times the average financial weighting among the fund’s large-value peers, and five times the weighting of financial stocks in the S&P 500. About 15 percent of that broad index is in financials, so index funds that track it typically are close to that number.

Fairholme’s fourth-largest holding was Bank of America, at 5.8 percent of a portfolio that included slightly smaller stakes in such banks as Goldman Sachs, Citigroup, and Morgan Stanley.

In his most recent letter to shareholder in late July, Berkowitz said he was still a believer in the financial stocks in his $11 billion fund. He urged patience.

“Often, we are ahead of the crowd, too early, and appear wrong for a time,” Berkowitz said.

He noted that many financial stocks rose to all-time highs after surviving the savings-and-loan crisis in the early 1990s.

Today, Berkowitz said, a similar “tipping point” may be at hand for financial stocks with enormous cash flows and diminishing costs from mistakes they made before the financial crisis. He added that banks’ prospects have improved because consumer credit ratings have reached their highest levels in four years.

Below are four other diversified funds with more than $1 billion in assets that had 30 percent or more of their portfolios in financial sector stocks, based on recent holdings reports:

— Clipper Fund (CFIMX), with 44 percent; John Hancock Classic Value (PZFVX), 34 percent; Franklin Balance Sheet Investment (FRBSX), 33 percent; and Legg Mason Capital Management Opportunity (LMOPX), 32 percent.

Plenty of big, diversified funds also are avoiding financial stocks. Here are eight $1 billion-and-up funds that listed no such holdings in their latest reports:

— Royce Special Equity (RYSEX); Amana Trust Growth (AMAGX); Brown Capital Management Small Company (BCSIX); FPA Capital (FPPTX); First Eagle Fund of America (FEAFX); Fidelity Growth Strategies (FDEGX); Brandywine Blue (BLUEX); and Amana Trust Income (AMANX). (The Amana funds are managed according to Islamic law, so they bar investments in banks that charge interest.)

Morningstar’s Milling warns against jumping to conclusions about funds with large stakes in financial stocks. That’s because risks vary widely among stocks that fall within financial services.

Consider American Express. Shares of the credit card issuer are up 8 percent this year. Customer spending reached an all-time high in the second quarter, and earnings jumped 31 percent. American Express was the largest recent holding at Clipper, a key reason why the fund has limited its loss to 3.4 percent this year.

Says Milling: “You really have to look under the hood when you’re considering the financials stake a fund has, because it’s such a big, diverse sector.”

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Questions? E-mail investorinsight(at)ap.org