Banking funds could outperform if economic recovery continues unimpeded

Global factors causing a slowdown and overexposure to this sector are key risks

The banking sector is on a roll these days. The Nifty Bank Total Return Index (TRI) is up 20.6 per cent year-to-date (YTD). The Nifty PSU Bank TRI has clocked a blockbuster gain of 55.7 per cent YTD. Actively-managed banking and financial services funds are up 10.9 per cent on average YTD.

Sound fundamentals

The improved performance of banking and financial services funds can be attributed to positivity in all the factors that drive the performance of banking stocks: growth, profitability, asset quality and balance sheet strength.

Credit growth is improving (17.9 per cent year on year in October 2022). “Moreover, the advance mix is favourably tilted towards retail loans, which are higher yielding,” says Ravi Gopalakrishnan, chief investment officer-equity, Sundaram Mutual.

Credit growth is expected to remain strong in the near future. “Pick-up in manufacturing, rise in system capacity utilisation, and emerging signs of private capex in several sectors augur well for a revival in corporate credit growth,” says Gopalakrishnan.

Banks’ margins are also improving. Gopalakrishnan says the external-benchmarked loans originated in the recent past will aid banks by passing policy rate hikes to customers faster than the increase in deposit rates (which will impact MCLR-based loans).

Banks are also facing lower credit cost as their asset quality has improved and they have to provision less for non-performing assets (NPAs).  

Most banks are also well capitalised. “Their capital adequacy ratios are at among the best levels in the past 5-10 years,” says Arun Kumar, head of research, Fundsindia.com.

Global risks

The banking and financial sector faces risks emanating from macro factors like the sharp global slowdown, rupee depreciation, and systemic liquidity constraints.

Roshan Chutkey, senior fund manager, ICICI Prudential Mutual Fund warns that the strong dollar and the high interest rate environment could lead to event risks like the ones being witnessed currently, such as a global bank experiencing severe stress, the failure of crypto exchanges, and so on. “One has to be wary of such event risks as they may result in dire situations like tightening credit markets and other financial contagion risks,” he says.

Interest rates in India are rising. While the Indian economy is in a relatively better shape, consumer balance sheets are not yet in the best of positions to absorb higher rates. “Slowdown in credit growth is a distinct possibility on account of higher rates, liquidity tightness, and a potential slowdown,” says Chutkey.

With inflation still at elevated levels, the US Federal Reserve may find it difficult to implement easing measures quickly. However, says Chutkey, if the US Fed were to turn dovish, all these above-mentioned worries would subside and banking funds would continue to outperform.

On balance, the outlook seems positive. “In the medium to long term, the macro stability of our economy, the low level of leverage in the economy, and the sector’s growth potential should aid the returns of these funds,” says Chutkey.

Should you invest?

One risk of investing in a banking and financial services fund is that of overexposure. “Financials are already well represented with an exposure of 30-40 per cent in most diversified-equity funds and at the index level. If you take an additional tactical exposure, you could end up with 45-50 per cent exposure to financials,” says Kumar.

The banking and financial sector tends to take a big hit in the event of an economic slowdown or a market crisis. Overexposure to this procyclical but volatile sector could exacerbate the hit to your portfolio. Aggressive investors with high conviction should first check their existing equity portfolio exposure to this sector and then take an incremental exposure of 5-10 per cent at the most.   

“Retail investors should go with a broad-based rather than a niche fund in this category, so that the fund manager has some leeway if a sub-segment turns expensive,” says Kumar.   

In view of the existing macro risks, Chutkey suggests selecting an active fund whose manager has a proven track record of managing risks.