Banking, financial services funds: Enter via SIPs with a 5-year view

If loan growth does not rise towards the 12-13 per cent range, valuations may shrink

While the Sensex has delivered only 3.5 per cent over the past year, banking and financial services sector funds have returned an average of 11.5 per cent. After this sharp run-up, however, investors need to enter these funds with caution. 

Earnings-driven rally 

An accommodative regulatory environment has strengthened the sector’s fundamentals. “There is lower pressure on liabilities today than last year. The proposed regulatory changes on liquidity coverage ratio (LCR), project provisioning and risk weights have been more supportive of growth than those suggested in the draft regulations,” says Milind Agrawal, fund manager, SBI Banking & Financial Services Fund. 

The lending segment — comprising small and mid-cap banks, PSU banks, non-banking financial companies (NBFCs) and large private banks — has led the rally. “System-wide credit growth has edged up to around 11 per cent year-on-year. Q2FY26 earnings across banks exceeded expectations. Net interest margins (NIMs) surprised positively, aided by prudent liability management and a favourable product mix,” says Preethi R S, fund manager, DSP BFSI (banking, financial services and insurance) Fund. Milind Agrawal notes that although lower interest rates are negative for margins in the short run, lenders have managed this impact well. 

Asset-quality concerns in unsecured lending have eased, supporting a recovery in personal loans, credit cards and microfinance. NBFCs with diversified retail portfolios and disciplined borrowing costs have also gained from steady growth, partial rate transmission and stable asset quality. Valuations have witnessed a mean reversion after a subdued FY24.

 

Rally’s continuation hinges on growth 

An improving growth environment and stable asset quality would support valuations. “If we see an improvement in credit growth, which currently seems to have bottomed out, sectoral earnings could get upgraded,” says Milind Agrawal.

 

Front-loaded GST rate cuts and tax incentives have revived consumption sentiment. “Credit growth, which was muted at around 10 per cent in FY25, is likely to improve to 12–13 per cent, enabling larger banks to deliver stronger earnings momentum,” says Preethi. She adds that expected rate cuts of about 100 basis points over FY26 could boost consumption-led credit demand.

 

“The hit to margins can be mitigated over a period of time, such that overall profitability isn’t materially impacted,” says Agrawal. With NIM pressures easing and asset quality stable, Preethi sees healthy earnings visibility and potential for continued outperformance.

 

Credit growth must accelerate 

A slowdown in growth remains the biggest risk. Fund managers say that if system loan growth fails to accelerate towards the 12–13 per cent range, valuations may lose support.

 

Over-aggressive rate cuts could further compress NIMs. External risks also persist: a delayed or unfavourable US tariff deal may weaken SME (small and medium enterprise) exporters, while an RBI clampdown on unsecured or NBFC lending could stall momentum in parts of the sector.

 

Outlook positive 

Experts remain constructive. “Lending growth, supported by policy tailwinds and improving liquidity, should drive mid-teens earnings growth over FY27–FY28,” says Preethi. A favourable US tariff outcome could further strengthen SME credit. Life insurers are expected to recover from GST-related effects, and their current valuations are attractive.

 

Higher Sebi oversight on derivatives and mutual funds may cause temporary volatility. But once the final guidelines are implemented, the segment should stabilise and contribute to the performance of BFSI funds.

 

Avoid over-allocation 

The BFSI sector accounts for over 36 per cent of the Nifty 50 and between 25–35 per cent of large-cap mutual fund portfolios, leaving limited room for additional exposure. The sector carries concentration risk and is highly sensitive to economic conditions. “During an economic downturn, banks and financial institutions can suffer from higher loan defaults, reduced credit demand and shrinking profits. This could lead to value erosion in BFSI funds in the short term,” says Ankur Punj, managing director and business head, Equirus Wealth.

 

Asset quality shocks also pose risks. “During the Covid-19 pandemic, when NPAs (non-performing assets) in Indian banks increased close to 10 per cent, banking stocks faced significant stress, leading to sell-offs in banking stocks,” says Aditya Agarwal, co-founder, Wealthy.

 

Higher interest rates can hurt bank and NBFC margins. Deterioration in credit quality or a decline in CASA (current account savings account) levels can further erode profitability. Being a heavily regulated sector, BFSI is also exposed to policy risks.

 

Tips for new and existing investors 

Investors may consider entering BFSI funds, but with discipline. “With low inflation, low interest rates, GST 2.0 and an increase in disposable income through tax cuts, the economy is expected to grow by a nominal rate of 11–12 per cent. BFSI will play a core part in this growth,” says Aditya Agarwal.

 

With valuations no longer inexpensive, prudence is called for. “Enter gradually via systematic investment plans (SIPs). Limit exposure to avoid concentration risk,” says Aditya Agarwal.

 

“Sectoral funds should not be more than 10–15 per cent of an investor’s overall equity portfolio. The ideal investment horizon should be five years,” says Punj.

 

Existing investors may remain invested if they have a similar horizon. “They should rebalance periodically if overweight on these funds,” says Punj.