Financial Sector Funds Struggle under Subprime Meltdown

The U.S. subprime debacle continues to be the focal point of global financial markets. News from financial institutions or hedge funds reporting either significant losses or facing liquidity. ....

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The U.S. subprime debacle continues to be the focal point of global financial markets. News from financial institutions or hedge funds reporting either significant losses or facing liquidity difficulty appears to dominate the headlines everyday. The global equity fallout of two weeks ago was a prime example the ripple effect the subprime meltdown had on the world economy. It also served as a clear refute to some of the initial theory that the U.S. credit issue should not spread beyond its borders. Financial stocks, being the epicenter of the whole crisis, were amongst the hardest hit. As of August 27, the MSCI World Financials Index fell 4.33% year to date. American financial companies tumbled badly as well: financials are 7.62% into the red this year, the worst among the ten S&P500 sectors.

Mortgage providers were the first domino to fall under the subprime fiasco. American Home Mortgage and Aegis Mortgage, the tenth- and thirteenth-largest mortgage provider in the U.S., both filed Chapter 11 bankruptcy petition earlier this month. The nation's largest lender, Countrywide, also faced serious liquidity difficulty and has to tap into its bank credit line after being shut out from the commercial paper market. Investment banks and security houses with sizable holdings in subprime-backed securities also suffered significant trading losses or provisions. Bear Stearns, the second largest mortgage backed securities underwriter, saw its share stumbled 33% since turning the calendar.

The U.S. Federal Reserve unexpectedly lowered its discount rate by 50bp to 5.75% on August 17, in an effort to increase liquidity in the credit market. The news was a shot in the arm for anxious equity investors worldwide. In the accompanying statement the Fed acknowledged that “downside risks to growth have increased appreciably” and abandoned mentioning inflation as its chief concern. Traders speculate the Fed to lower its benchmark lending rate as early as its next scheduled meeting in September, sending global equity markets to a remarkable rebound throughout the week.

However, the U.S. financial market is expected to remain unstable in the near future as investors stay skeptical about mortgage related securities. Stung by subprime related losses, money managers pour into government debt searching for safety, and those willing to bear risk are demanding higher yields in return. For example jumbo mortgage specialist Thornburg said it had to accept a 5% discount on its AAA-rated MBS before finding willing buyers. It is a sign that while the credit market is slowly resuming normalcy, investors' appetite towards risk are now much more prudent than before.

On the investment funds side, financial sector funds obviously struggled as well. According to Morningstar's data as of August 27, financial equity funds returned a collective -3.32% for the past 3 months, pinning the group among the laggard categories. Davis Financial has achieved a year to date return of 14.16%, the third best in the category. Davis' sector allocation is rather unique when compare with its peers: it overweights low-cyclical sectors insurance and diversified financials with holdings such as Transatlantic Holdings and Dun & Bradstreet, while underweights banking and brokerage, which had been quite volatile lately under the credit market woes.

Fund managers Ken Feinberg and Charles Cavanaugh embrace the buy and hold strategy, and tend to hold companies for several years. The portfolio is rather compact as it usually only invests in between 20 to 30 companies. Diversification is achieved through geographical and industry allocation. Investors would find emerging economy financial institutions such as India's ICICI Bank and China Life, along with capital goods conglomerate Tyco International on the portfolio investment list. The fund's standard deviation for the last three years is 8.45%, the lowest amongst its peers. Davis Financial could be a fund worth a deeper look for investors who feel optimistic about the long term prospect of American financial industry amid the subprime turmoil.

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