PSU bank ETFs and index funds: Rebalance instead of chasing momentum

New investors should take limited exposure with long horizon

The Nifty PSU Bank Index has surged 25.2 per cent over the past year. Several exchange-traded funds (ETFs) from fund houses, including Nippon India, Kotak, DSP, HDFC, ICICI Prudential, and Mirae Asset, track this index. SBI Mutual Fund offers an index fund based on the BSE PSU Bank Total Return Index (TRI).

 

Key drivers of the rally

 

Improving fundamentals fuelled the rally. “Asset quality has improved while non-performing assets (NPAs) have declined significantly over the past few quarters. PSU banks now outpace private banks in credit growth. Reduction in policy rates and the cash reserve ratio has lowered funding costs and supported credit expansion and margins,” says Satish Dondapati, fund manager – ETF, Kotak Mutual Fund. Supportive initiatives by the government, such as increasing the foreign direct investment (FDI) limit and the merger of PSU banks, have contributed to positive sentiment.

 

Will the rally sustain?

 

Strong fundamentals and a supportive policy environment continue to keep sentiment positive. Infrastructure-led spending is boosting loan demand, and PSU banks’ cumulative profits are at record highs. “The outlook for the PSU banking sector remains upbeat, underpinned by ongoing progress in parameters such as rising credit growth, recovery in margins, strengthening asset quality, contained slippages, and normalised credit costs,” says Dondapati. He expects these trends to sustain earnings momentum and aid further re-rating. 

 

Valuation gap remains

 

The index still trades at a significant discount to frontline benchmarks — nearly one-third the Nifty 50’s price-to-earnings (P/E) ratio. “Historically lower valuations stemmed from asset quality concerns. But the recent rally — driven by stronger fundamentals, improved asset quality, and robust credit growth — has helped PSU banks outperform the Nifty 50. With valuations still low and balance sheets strengthening, the gap is likely to narrow further,” says Dondapati.

 

Beware the risks

 

PSU banks are highly sensitive to economic slowdowns, and slippages often materialise before markets react. “NPA cycles are wider due to policy-influenced lending, unlike private banks, which have stricter credit filters and tighter risk controls. Margins and asset quality can come under pressure simultaneously if liquidity tightens or government-led capex loses momentum,” says Arun Patel, founder and partner, Arunasset Investment Services. With the clean-up cycle largely behind the sector, he warns that new stress may hit balance sheets faster.

 

Index investing limits discretion. “A PSU bank index fund includes all index constituents according to their set weights, whether you like them or not,” says Santosh Joseph, chief executive officer, Germinate Investor Services. The concentrated nature of the index could also magnify risk.

 

Enter now?

 

New investors should proceed cautiously. “The index is no longer as attractively valued as it was during the balance-sheet repair phase. Much of the re-rating happened as credit costs fell and profitability improved,” says Patel. He points to governance challenges — slower decision-making, diffused accountability, and policy-linked lending — as ongoing concerns.

 

Joseph points out that many diversified equity funds already have PSU bank exposure, reducing the need for a dedicated index fund. Only those seeking a high-conviction bet should consider this narrow strategy, he says. Others may go for diversified equity funds, perhaps with slightly higher PSU bank allocation.

 

Patel advises keeping any exposure small and tactical via an ETF and avoiding positioning it as a core holding. Investors should track NPAs, slippages, and provisioning trends closely. He suggests trimming exposure early if capital buffers weaken or policy-driven lending rises.

 

Time to rebalance

 

Existing investors, according to Patel, should rebalance instead of chasing momentum. He recommends reducing exposure if valuations outpace fundamentals while watching for sudden increases in credit costs. Joseph advises assessing whether such a concentrated index truly adds value to the portfolio and aligns with one’s risk appetite. 

 

The writer is a Delhi-based independent journalist