Financials lead rally in equity funds: Morningstar

July was another great month to own financial services funds — as confidence that a recovery is underway increased, so did the fortunes of the beaten-down sector, according to preliminary performance data released today by Morningstar Canada.

Strong performance in financial services led Canadian equity funds to a fifth consecutive month of positive results in July.

Forty of the 43 Morningstar Canada Fund Indices advanced during the month, led by the Morningstar Financial Services Equity Fund Index, which posted a whopping 9.8% gain on the month.

“The financial services sector showed renewed signs of life in July as corporate earnings reports helped drive speculation the industry may be starting to turn a corner,” says Neal Brandon, fund analyst for Morningstar Canada. “Major U.S. banks, including Goldman Sachs and JP Morgan Chase, reported better-than-expected earnings during the month, benefiting from common themes of strong underwriting fees and increased trading revenues. In Canada, life insurers and asset managers were buoyed by the renewed confidence and positive performance in the equity markets.”

Many investors had left financial service stocks for dead in the early part of this year, but the last quarter has seen a significant run-up. Using Morningstar’s fund quick rank tool for the Financial Services Equity Fund Index brings up a number of mandates well in excess of 30% positive returns over the last three months.

What’s also apparent is a large chasm between the run-up in valuations and how far they had fallen. Many of the funds in this category are still down in excess of 20% on the year.

As a dividend-rich category, financial stocks were also the main contributor of returns for sector-diversified domestic equity funds. The Morningstar Canadian Dividend & Income Equity Fund Index, whose constituent funds on average allocate 42.5% of their assets to financials, posted the second-best return among fund indices with a 5% gain.

The Canadian Equity and Canadian Focused Equity fund indices also hold more than a quarter of their assets in financials, and were up 4.1% and 3.9%, respectively, ranking third and fifth in performance on the month.

July also saw a strong run-up in foreign equity funds. All major European, Asian, and Latin American stock markets outperformed the Canadian market. Morningstar notes their returns were significantly reduced by a strengthening Canadian dollar.

The Canadian dollar’s rise sapped the strength of what, in some cases, were double-digit returns in local currencies. Among foreign equity funds, the Asia Pacific Ex-Japan Equity category was the best-performing index in July, gaining 3.8%.

The Shanghai Composite Index gained 15.3%, supported by further government stimulus spending and improving investor sentiment. The sharp appreciation of the Canadian dollar against the Chinese yuan (7.8%), the Hong Kong dollar (7.7%), and the South Korean won (3.3%), among others, detracted from those returns.

In the United States, the S&P 500 Index’s 7.6% gain was “virtually wiped out” by the U.S. dollar’s 7.2% drop against the loonie, Morningstar says, resulting in a modest 0.6% gain for the Morningstar U.S. Equity Fund Index.

Similarly, the European Equity, Global Equity, and International Equity fund indices were up just 1.6%, 1.9%, and 2%, respectively.

“The Canadian dollar rebounded sharply in July, supported by a run in commodity prices and a return of risk appetite in the equity markets,” Brandon says. “The commodities rally was driven by the prospect of increased demand from emerging markets and increased optimism that the economic downturn may be easing. The Bank of Canada helped to reinforce this optimism with its forecast for moderate growth over the quarter, drawing a line under the recession and setting the tone for economic growth.”

Tomorrow: Opportunity in financial sector dries up.

(08/05/09)