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David Stevenson: a tried and tested fund for all seasons

David Stevenson: a tried and tested fund for all seasons

Amongst most private investors, sector funds have rather fallen out of favour in recent years.

There is of course real enthusiasm for sectors and themes that are fashionable, especially technology stocks, but outside of this hot spot, most investors tend to prefer either an outcomes-based solution – absolute returns or income – or a more general geographical approach.

This is all rather a pity because some sector funds can provide a dual purpose, namely, they give you exposure to a sector full of stocks but with desirable characteristics which produce certain outcomes.

The best way to explain this is to shine a light on another of my Hidden Gems, the Polar Capital Global Insurance fund. This is pretty much a unique fund, although there are some financial services fund which have exposure to insurance businesses as a side pocket.

Defensive qualities

My sense is that if you are looking for a defensive sector, with an ability to withstand any market volatility, you might think about starting with big commercial insurance companies.

First though, a definitional point. When most UK investors think about insurance, they tend to conjure up names such as Legal & General (LGEN) or Aviva (AV).

These are both excellent businesses and I hold shares in the former, but in truth they are conglomerates which combine (to varying degrees) asset management with very competitive high street style insurance.

Asset management is a great business for all the reasons I detailed last week but it can be cyclical, with revenues tracking the stock market cycle up and down.

Highly competitive household and car insurance is less cyclical in that sense, but it is unfortunately also increasingly competitive with wafer-thin margins. That said there are some great businesses kicking around amongst the high street brand names (I like Direct Line (DLGD) for instance) but investors seem to live in permanent fear of another price war breaking out.

Mainstream commercial insurance is a rather different affair and takes in everything from reinsurers and outfits focused on working within Lloyds of London through to big insurance agency businesses that write commercial finance day in, day out.

Familiar names include Marsh & McLennan which also has a strong consulting arm (Oliver Wyman) alongside less familiar names such as Arch Capital which writes very specialist insurance for a legion of businesses.

All of these varied business models tend to have a common characteristic – they provide an essential (non-discretionary) service that doesn’t go away with an economic downturn and which helps dampen down volatility and uncertainty for the buyer of the insurance.

These also tend to be very focused businesses with a real niche with strong operating margins for the right under writers. A good example of this is Hiscox (HSX) which has built a great franchise in specialist business and high-end home insurance or Randall and Quilter (RQIH) which manages run-off portfolios for life assurers. Stockmarket cycles have an impact on these businesses but the volatility is nowhere near that of, say, bank stocks or asset managers.

Tested in the crisis

We can see this clearly in returns from the Polar Capital fund in 2008, which were essentially flat. The flipside of this is that these portfolio businesses tend to underperform in a business cycle – very few private investors are going to want to own stocks in boring insurers if they can buy Google owner Alphabet (GOOGL.O) or Tesla (TSLA.O) instead!

My sense though is that are we late cycle and that for now, we may have seen the best of the gains in many technology-driven disruptors – which is not to say that the long-term growth narrative for technology isn’t intact.

My point is simply that many momentum-driven sectors might see more volatility in their share price in the next few years while more defensive sectors, such as insurance, boast businesses with stronger finances and better defensive characteristics. We can see this clearly in the cashflows delivered to shareholders via dividends and share buybacks. The average yield on the Polar fund is around 2% but the managers reckon another 3% or thereabouts is dropping down to shareholders via buyback programmes run by big US business. That adds up to a distribution yield (dividends and buybacks) of around 5%.

Cynics might point to the rise of insuretech and the growing army of tech-enabled insurance disruptors lurking in the shadows, ready to shred those high margins which produce the abundant cash flows. To which I’d say you might be waiting for some time.

I can see direct-to-consumer products being heavily disrupted, in commercial insurance I think the chances of disruption are minimal, if not beneficial i.e they might help to cut costs.

Regulation also sometimes, though not always, helps. Regulators are painfully aware that an insurer with a poor balance sheet is a potential systemic risk (and a potential customer nightmare), so they insist on strong finances and margins.

Then there’s the very real risks of climate change and the impact on insuring against wind and fire that is a feature of the reinsurance or catastrophe insurance markets. This has been a disastrous niche market for many operators in recent years but to date, it seems that most big insurers have mitigated the impact by raising prices to consumers and sharing out the risk with specialist reinsurers who have frequently underbid the cost of insurance and taken on too much risk.

Concentrated approach

For me, though, the key point is that trying to second guess these trends and hazards is a dangerous pursuit for investors. Active fund management is essential in this space if only to avoid the inevitable insurance industry cock-ups.

And the Polar Capital Global Insurance managers certainly know the sector. They started working for Hiscox the insurer many moons ago, running an internal investment fund, before moving over to Polar about a decade ago. Their long track record shows relative outperformance against the benchmark index, and, as I said earlier, a defensive style of equity investing.

Over the last 10 years the fund has returned 217% and since launch has produced annualized returns of 9.4%. Nick Martin now runs the fund – former co-manager Alex Foster is slowly stepping back from front line management – and has a tight portfolio of around 30 to 35 stocks, which is exactly what you want from an active fund manager. No closet index tracking here!

The fund is US weighted, which is no bad thing, but there is always that currency risk which could have an impact on future returns. It hasn’t really been marketed at retail investors, though it is available on most platforms and its investor base is largely made up of institutional fund managers and some wealth advisers.

Financial advisers and retail investors don't feature prominently as holders, which is a pity in my view. I think this could be an ideal defensive fund and frankly, its returns have been better than many equity income, or more defensive managed and absolute return funds, with similar if not lower levels of volatility. 

Any opinions expressed by Citywire or its staff do not constitute a personal recommendation to you to buy, sell, underwrite or subscribe for any particular investment and should not be relied upon when making (or refraining from making) any investment decisions. In particular, the information and opinions provided by Citywire do not take into account your personal circumstances, objectives and attitude towards risk.

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