This article was originally produced in conjunction with Boring Money for their Investment Trust Hub.

Some information contained herein has been obtained from third party sources and has not been independently verified by Polar Capital. Neither Polar Capital nor any other party involved makes any express or implied warranties or representations.

With several banks in the news for all the wrong reasons lately, there’s been a sizable uptick in interest in the financials sector. While perhaps not as popular with investors as, say, the technology or healthcare sectors, financials stocks appear in many of the most popular funds and investment trusts in the UK, and many investors will have more exposure than they might even be aware of.

Banks and financial services stocks make up a significant proportion of some of the biggest stock market indices in the world - 15% of the FTSE 100 and MSCI World Index, 11% of the S&P 500 and more than 10% of Euro STOXX – and by extension many of the best-selling passive funds (which aim to ‘track’ or replicate an index or market sector) and investment trusts, including the Fidelity World Index Fund and the City of London Investment Trust.

But with news of the collapse of two American banks - Silicon Valley Bank (SVB) and Signature Bank - and the last-minute rescue deal of Credit Suisse by UBS (which Swiss authorities helped to orchestrate), many investors felt apprehensive about their exposure to the financials sector altogether. Are the recent events in the US and Europe symptomatic of a brewing crisis amongst the banking sector? Is there good reason to rethink investing in financials? Or is the turbulence of late more of a transitory wobble than a seismic event?

What’s going on with the banks?

First of all, let’s recap on what’s actually happened with the banks recently. In March, several US banks with exposure to the technology and cryptocurrency sectors - Silvergate Bank, Silicon Valley Bank (SVB) and Signature Bank - collapsed and triggered the largest bank failures in the United States since the 2008 financial crisis. In fact, the collapse of SVB marked the second-largest bank failure in US history. And shortly afterwards over in Europe, troubled Credit Suisse was hastily acquired by rival bank UBS in a Swiss government-backed deal to prevent its own collapse.

Though there are several factors which contributed to the recent turmoil, and regulators are no doubt still picking apart the details, much of the blame has been apportioned to critical risk mismanagement, rather than systemic issues in the banking sector as a whole.

Though there are several factors which contributed to the recent turmoil, and regulators are no doubt still picking apart the details, much of the blame has been apportioned to critical risk mismanagement, rather than systemic issues in the banking sector as a whole. This is perhaps most evident in the case of SVB.

For a large portion of last year, SVB didn’t have a Chief Risk Officer (CRO). Its previous CRO, Laura Izurieta, stopped working in April 2022, but it wasn’t until December that her replacement was appointed. Some early-stage SVB lawsuits are already assessing the significance of the vacancy. Reed Kathrein, a lawyer who specialises in corporate governance, told Bloomberg that, given the SVB’s risk committee was reportedly continuing to hold regular meetings right up until its collapse, "it means perhaps management was hiding something or didn’t want to disclose something, or had disagreements over the risks it was taking".

Meanwhile, there were bigger issues brewing at SVB. As a popular lender to tech companies – which boomed during the pandemic as everyone relied heavily on Zoom, Skype, online shopping and the like – SVB had seen huge inflows of deposits. Good news for SVB, but its mistake was that it invested much of those deposits in long-dated government bonds – and therein lies the problem. Because bond prices move inversely to interest rates, as the US Federal Reserve (Fed) hiked rates, SVB’s bond-heavy portfolio tumbled in value.

Not the end of the world in and of itself. But, as the cost of living climbed sharply in 2022 and tech companies – grappling with a dip in revenues almost across the board – started to draw on their deposits to help ends meet, SVB (though initially able to meet these requests) resorted to borrowing money as the outflows continued into 2023. Finally, it was forced to sell as it didn’t have enough cash available to fulfil the demand.

So it sold some of its bonds in an attempt to raise the cash, but in many cases at a significant loss, while asking shareholders for further capital to cover the loss, which then raised concerns among investors and customers about SVB’s stability. As news of the bond sales spread, nervous customers quickly withdrew more than $42 billion worth of funds within 24 hours, triggering a so-called ‘bank run’ (when customers flock to make withdrawals because they’ve lost confidence in the bank). SVB formally collapsed less than 2 days after it all began.

Its top executives have received criticism, notably from Fed officials, for not adequately foreseeing and managing the risk of its bond-heavy portfolio in advance of the well-publicised rate hikes – a "textbook case of mismanagement", according to Michael Barr, the Fed’s Vice-Chair for Supervision, rather than a symptom of a systemic underlying issue within the financials sector as a whole.

Signature Bank and Credit Suisse have had similar falls from grace in recent weeks, and a very small - but loud – cohort are still concerned that another banking crisis, a lá 2008, may be on the horizon.

Do investors need to be worried?

So does the collapse of US banks and the last-minute rescue deal of Credit Suisse mean that investors should be worried? As is always the case, it really comes down to what you’re invested in and what proportion of your portfolio is allocated to funds or shares that are exposed to the banking sector. If you do have a meaningful amount invested in financials, you might be wondering if it’s time to rethink your allocation and reduce your exposure to financials – but is this really necessary?

Polar Capital Global Financials Trust (PCFT Financials), the only UK-listed investment trust focused purely on financials, aims to grow investors’ dividend income and capital by investing in a global portfolio consisting of companies in the financials sector operating “in the banking, insurance, property and other sub-sectors”. Essentially, with around 50% of its portfolio weighted to banks, it’s especially exposed to any peaks and/or troughs in bank stocks and the sector as a whole, and thus is an apt example of a trust that is particularly affected by what’s happening in the financials industry.

Nick Brind and George Barrow, co-Fund Managers at PCFT Financials, maintain that the sector "overall remains well capitalised, with strong forward earnings estimates and structural growth opportunities”. Essentially, they believe that there’s no reason to believe that recent events indicate a fatal blow. In fact, they suggest, the new record-low valuations offer investors an opportunity to capitalise on the sector’s long-term recovery potential.

In our view, this is not GFC2 [Global Financial Crash 2], but it is a mini-banking crisis.

Speaking at the PCFT Financials AGM on 30 March, Brind reflected on the recent turmoil around banks and the likelihood that this represents a systemic risk to the sector: “In our view, this is not GFC2 [Global Financial Crash 2], but it is a mini-banking crisis. Consequently, valuations have hit historic lows both in absolute and relative terms. However, capital return remains underpinned by strong balance sheets and profitability and the current contagion fears, we believe, are overdone and creating longer-term opportunities”.

Of a similar sentiment, Augmentum Fintech - another investment trust which invests primarily in the financial services sector - released a statement shortly after the collapse of SVB to reassure investors that it had “no direct exposure” to SVB and that its own cash reserves remained robust at approximately £40 million, as at 12 March 2023. No immediate causes for concern there either then.

To further soothe investors’ fears, the Governor of the Bank of England, Andrew Bailey, told the BBC that the UK banking system is “well-capitalised and funded, and remains safe and sound”. So although bank shares have wobbled over the last couple of months, there is little evidence at this stage to suggest that there are systemic underlying issues at play that pose a risk to the entire sector. What we’re seeing appears - so far - to be a few isolated cases where pre-existing problems have been exacerbated by interest rate hikes and rising inflation.

How are fund managers responding?

So how have the fund managers at PCFT Financials been responding to recent events in the financials sector? There have been some subtle adjustments to the weighting of the portfolio – particularly in regard to US medium and small-sized banks – but the overarching sentiment at PCFT Financials remains that there is little need for a knee-jerk reaction; the foundations of the financials sector remain strong, and in fact, events of late provide an opportunity for investors to benefit from the longer-term recovery.

In the PCFT Financials AGM on 30 March, Barrow explained: “In terms of the breakdown of the portfolio, banks remain the largest subsector – just over 50% of the trust. More recently, we have reduced our US bank exposure through reductions in our SMID-cap space [small and medium-sized cap companies], where we currently have under 1% exposure.”

In an article on 14 March, PCFT Financials’ fund managers gave more details on the reasoning behind their decision to reduce exposure to smaller banks, stating: “Small and mid-cap US banks are likely to see greater regulatory oversight in view of current events” as they previously “had much less onerous regulations than larger systemically important banks”.

They anticipate that these banks “will see added pressures on their margins due to rising deposit costs and have few alternative levels of revenue, unlike major banks with large market-sensitive operations". The verdict? Reduce exposure to minimise risk in the short to medium-term.

At the AGM, Barrow also confirmed that PCFT Financials has also trimmed its European bank exposure “post-events at Credit Suisse”, but that it still remains “overweight in this space, where we continue to see a supportive backdrop from [higher interest] rates and high levels of capital return”.

What’s the outlook for financials?

So what can we expect to see in the financial services space over the course of 2023? Up until now, many investors have been apprehensive about financials, in part due to lingering wariness from the GFC global financial crash back in 2008, and recent events have done little to soothe these fears. Lots of people still see banks as a potentially risky investment, and although regulations have tightened in the major economies to prevent a repeat of previous events, demand for financials remains comparatively lower than other sectors. According to Fidelity, in late 2022 financials were among the cheapest sectors in the S&P 500 index and – interestingly – also cheap relative to the sector’s own historical valuations. In other words, interest in financials stocks and funds is pretty low.

The vast majority of the largest banks maintain healthy balance sheets and, though some nerves have been shot and caused share prices to slide recently, they say that these recent low valuations offer a unique opportunity.

But does this in itself represent an opportunity for investors? Though there’s no crystal ball for us to predict what’s going to happen over the rest of 2023 – whether more banks will fold or the long-dreaded global recession will strike deeper than anticipated – many expert commentators maintain that the foundations of the financials sector as a whole remain strong. The vast majority of the largest banks maintain healthy balance sheets and, though some nerves have been shot and caused share prices to slide recently, they say that these recent low valuations offer a unique opportunity to invest and take advantage of the longer-term recovery of the sector.

Martin Zschech, Global Head of Industry Solutions and Client Management at Allianz Global Corporate & Specialty (AGCS), weighed in with his thoughts on the outlook for financials. He acknowledges that although financial services are “not immune to the challenges facing other sectors” - such as inflation and rising interest rates - many analysts now consider systemic risk to the sector to be low “as large lenders are much stronger financially than they were before the financial crisis in 2008”.

Although Zschech cautions that some have said that “more shutdowns and seizures in the US are possible” he adds that regulators will "be watching for signs of more instability across the sector very carefully” and should be better prepared to intervene - should there be a next time.