Cinderella steps out

Alison Eadie continues her series on specialist funds

Financial funds often feel as though they are investment Cinderellas - ignored, unloved and put-upon. But for those who run them, there is an increasing expectation that they are about to get to the ball after all. The specialist funds they represent invest in the shares of banks, insurance companies and other financial services businesses, including investment trusts.

The dwindling band of such specialist unit trusts - there are only four left after Barclays Unicorn Financial Trust converted to a FTSE 100 index tracker fund in August - occupy a separate category with property funds in the Association of Unit Trusts and Investment Funds directory.

However, Autif is set to recategorise the funds in the new year, which could herald the start of their fight for recognition. Richard Peirson, manager of Framlington Financial Fund, says that being parked in a sub- sector has caused financial funds to be overlooked, despite the good performance of some. "When our fund moves into the international growth sector, where it sits naturally, we will come near the top of the pile and independent financial advisers will start to focus on us," he says.

In the five years to October, Framlington Financial grew by 174.8 per cent, while Save & Prosper Financial Securities Fund grew by 172.1 per cent. Over the same period, funds analyst Micropal shows the international equity growth average was up 87.4 per cent. In a field of 126 unit trusts, Framlington Financial was beaten by just three funds - two technology and its own healthcare fund.

The international label does not apply to financial funds equally. Framlington is highly diversified, with only 25 per cent of its assets in the UK and the lion's share of 40 per cent in the US. S&P Financial has closer to 60 per cent invested in the UK, Edinburgh Financial Fund 70 per cent and Hill Samuel Financial Trust 71 per cent.

Whatever the geographic split, financial funds aim to deliver above- average growth in the long term from an industry sector that is growing and globalising fast. With predictions being made that just 30 big players will dominate the global insurance scene within 10 years, a fund manager's job is to pick the likely winners.

Chris Jeffrey, manager of Hill Samuel Financial Trust, says: "The long- term winners will be companies with a strong brand name and good distribution channels providing the right products at low cost."

Growth prospects for financial services are based on demographics. An ageing world population and the inability of governments to fund theretirement needs of their citizens offer many opportunities, particularly in pension provision and long- term care. Technology will continue to provide opportunities for efficiency gains and cost-cutting in the banking sector. The US and the UK are already well down the consolidation road, but Europe is only setting out.

Both the Framlington and S&P funds have been increasing their European weightings recently. However Robin Evans, manager of S&P Financial, says that finding attractive European companies earning a decent return on equity is not easy.

As well as geographic asset allocation differences, financial funds invest in different types of company within the financial services sector. Framlington Financial has a third of assets in big banking and insurance groups and two thirds in smaller, niche companies. Mr Peirson says smaller, specialist companies are often accorded lower market ratings than big companies but deliver faster growth.

By contrast, S&P Financial concentrates on mid-size to large companies and Hill Samuel Financial invests mainly in the banking and insurance constituents of the FTSE 100 share index. Over five years to the end of October it grew by 127.2 per cent.

The rating of financial funds depends on their geographic bias and their exposure to large or small companies. Mr Peirson believes Framlington Financial is lower risk than specialist technology or healthcare funds because financial services stocks tend to be less volatile.

Mr Jeffrey says that unit trust rules limiting the concentration of assets to no more than 10 per cent in one company can be awkward when big banks are the key drivers of growth. He points out that HSBC Group, the banking giant which owns Midland Bank, makes up about 18 per cent of the FTA Financials index, a weighting he cannot replicate in the fund.

The rather more slow-moving financial services world can be threatened at the edges by developments such supermarket banking, but the oligopoly position of the big ones ensures them some protection, says Mr Evans. The biggest risks are inflation and interest rates.

Framlington's exposure to smaller companies and non-traditional financials makes it less sensitive to rising interest rates and bond yields.

If markets turn bearish, financial unit trusts have the scope to increase holdings in investment trusts. S&P holds Temple Emerging Markets and Hill Samuel 3i and Electra, although these trusts are not invested in financial services.

For the moment, however, bearish thoughts have been banished. Even if interest rates pick up in the US and UK, the swing is not expected to be dramatic and high unemployment levels in Europe should keep the lid on rates there. The outlook for financial funds is set reasonably fair, fund managers believe.