Do Banking and Financial Service Funds Look Attractive in a post-COVID-19 Era?

Nov 9, 2020

Ever since the coronavirus pandemic outbreak, the banking and financial sector has grossly underperformed the broader markets. 'Financial' is an index-heavy sector which accounts for 35.5% of the Nifty 50. The overhang of the moratorium and the Reserve Bank of India's (RBI's) cautious commentary on Non-Performing Assets (NPAs) had dampened the investor sentiments. Nevertheless, things appear to be changing for the better now.

During the Q2FY21 earnings season, which is presently underway, 'financials' have pleasantly surprised investors. Many private sector banks and the frontline Non-Banking Finance Corporations (NBFCs) have reported an all-round performance: rise in the Net Interest Income (NIM), healthy deposit growth, and improvement in the asset quality, among others.

If you remember, the RBI in its Financial Stability Report released in July 2020, had estimated that COVID-19 pandemic may push sector's NPA to 12.5% in by March 2021. However, Q2FY21 earnings of the banking and financial sector suggest that the situation may not be as gloomy as thought earlier.

Most of the leading private-sector lenders and the largest public sector bank --- the State Bank of India (SBI) --- have projected two different NPA scenarios: one considering the Supreme Court of India's interim order dated September 3, 2020, refraining banks from classifying borrower account as NPAs till the final order is out; and two, by classifying NPAs for the sake of argument.

And these two do not paint a very terrifying picture as of now. In fact, certain large lenders have raised capital during the pandemic time to tackle potential stress.

Of course, the clear picture may emerge only in the coming quarters, but the going has been good so far.

Graph: A lot to catch up for the Bank Nifty

Currently, a lot of banks and Non-Banking Financial Companies are making the best use of digitalisation to grow, gain a bigger pie of deposits and advances, and functioning with more sophistication.

On this backdrop, many of you might be wondering if the prospects of the Banking and Financial Services Funds have changed for the better and whether you should invest in them at this juncture.

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What might work in favour of the banking and financial sector?

Well, here are a few points that will work in favour:

1. Healthy regulatory oversight and responsive policy action.
2. Enhanced spending on infrastructure, speedy implementation of projects and continuation of reforms - all of which may provide further impetus to growth in the banking sector.
3. The initiatives taken by the government as regards financial inclusion and delivery of Digital Financial Services with Aadhaar linking.
4. The banking and financial sector investing in better technology to enhance the customer experience.
5. Increasing working population and growing disposal income, which would raise the demand for credit.

If banks continue to walk a tight rope on asset quality; the positive surprises cannot be ruled out. The profitability of banks shall improve and in turn, the Bank Nifty will fare better.

And what may work against the banking and financial sector?

• An unforeseen rise in NPAs.
• Potential lockdowns if India witnesses the second wave of coronavirus, similar to the one witnessed by Europe.
• A prolonged lull in the economy.

Historically, the sector hasn't disappointed investors. However, its performance being linked to that of the economy, the banking and financial services sector has been quite cyclical. Menace of NPAs in the aftermath of the 2008 financial crisis and the lacklustre economic performance post demonetization did negatively impact Banking and Financial Services Funds.

Table: Report card of Banking & Financial Services Funds

As exhibited by the table above, only a few of banking sector funds have outperformed Nifty Bank-Total Return Index (TRI) and Nifty Financial Services-TRI across time frames. The strong outperformance of Nifty Financial Services over Nifty Bank-TRI denotes that some NBFCs and insurance companies have added a zing to the performance of the index and also to the mutual fund schemes investing in them intelligently.

Should you invest in Banking and Financial Services Funds?

Looking at the present trends it appears that the frontline banks and NBFCs, especially in the private sector, may continue to have an edge over others. As you may know, top-5 stocks of Bank Nifty make up approximately 88% of the index; of which 4 are private sector banks. The same set of banks accounts for approximately 64% of Nifty Financial Services. Therefore, irrespective of any benchmark a banking sector fund may follow, it's likely to be compelled to hold a concentrated portfolio.

The pace of economic recovery will play a crucial role in the overall performance of the banking sector. A strong second wave of COVID-19 in Europe has vastly affected economic activities in several countries there. If new COVID-19 cases resurge during the winter months in India, it could force the government to restore several restrictions to contain the spread of the deadly pathogen, and that, in turn, may weigh on the economic growth, impair the asset quality of banks, NBFCs, and performance of Banking and Financial Services Funds.

Given that the most of equity diversified funds can give you adequate exposure to banking and financial services sector; it would be wise to skip the idea of having a Banking and Financial Services Fund in your investment portfolio.

If you want to benefit from the current market upswing and the rally in the financial services sector without compromising on your long term goals and risk appetite, follow a unique 'Core and Satellite' investment strategy.

'Core and satellite' investing is a time-tested strategy followed by some of the most successful equity investors.

[Read: Your Guide To Build An All-Season Mutual Fund Portfolio]

The 'Core' component should comprise of long term holdings that give stability to your portfolio, whereas the term 'Satellite' applies to the strategic portion that would help you accelerate returns across market conditions. Moreover, the 'Satellite' portfolio provides the opportunity to support the 'Core' by taking active calls based on extensive research.

Your 'core portfolio' should consist of a large-cap, multi-cap, and a value style fund, while the 'satellite portfolio' may include funds from the mid-cap category, a small-cap and/or a Hybrid Equity fund.

At PersonalFN, we believe the 'Core' holdings should account for 60% of your mutual fund portfolio and the rest 40% should consist of 'Satellite' holdings.

Following are the six benefits of 'Core and Satellite' approach:

1. It facilitates optimal diversification
2. Reduces the need for constant churning of your entire portfolio
3. Reduces the risk to your portfolio
4. Helps you benefit from a variety of investment strategies
5. Aims to create wealth, cushioning the downside
6. Offers the potential to outperform the market

That said, it is important to select well-researched mutual fund schemes that offer you stability at the core and the satellite portion helps you accelerate the return.

If you wish to invest in a readymade portfolio of top recommended equity mutual funds based on the 'Core & Satellite' approach to investing, I recommend that you subscribe to PersonalFN's Premium Report, "The Strategic Funds Portfolio For 2025 (2020 Edition)". This premium report will help you build your optimum mutual funds portfolio for 2025 without any effort on your part. If you haven't subscribed yet, do it now!

Happy Investing!

Author: Rounaq Neroy

This article first appeared on PersonalFN here

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PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

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