Banking Funds: Are they driving in top gear?
Oct 25, 2011

(Source: World Bank)

In fact the data sourced from the World Bank also exhibits (see table above), how over a decade the banking sector has ascended credit (as percentage of GDP) in case of developed as well as developing economies.

Banking and Financial Services Sector in India

India’s banking and financial services sector stands on strong foundations of very prudent policy framework laid by the regulator(s). Hence even when the U.S sub-prime mortgage crisis occurred, followed by Lehman Brothers bankruptcy; India’s banking sector especially did show enormous resilience due to effective risk management measures adopted. Even today while we are feeling the shivers of the economic headwinds flowing from the Euro zone, along with anti-inflationary stance maintained by RBI, the underlying robust fundamentals makes it look promising.

The Indian economy today has grown at a blistering pace in the last decade, and so have some banks and financial services companies. In the last decade, Indian banks and financial services companies have not only expanded their client base but have also brought in efficiency in their operations (enabled by technology), thus resulting in better quality of service. Also, with some of the companies being on an expansion mode, accessibility too has increased. But a noteworthy point is, the rural areas are still unbanked as the cost of mediation remains high clubbed with the problem of financial literacy. Hence to bring in financial inclusion, the Finance Minister (in his Budget 2011 speech) has encouraged private sector participation, but how the objective of financial inclusion will be attained is yet to be seen.

Banking and Financial Services Sector Funds

Promising investment opportunities offered by the banking and financial services sector, also have encouraged mutual fund houses to launch funds focusing on this domain. In May 2003 Reliance Mutual Fund was the first fund house to play this theme (with the launch of Reliance Banking Fund ), followed by UTI Mutual Fund in August 2005, and the others in the year 2008.

In the years gone by market capitalisation of the banking sector has gone up significantly; and today the banking and financial services sector occupies a dominant weightage in the BSE SENSEX.

In fact the table above reveals, that almost a quarter of index (i.e. BSE Sensex) is held by companies in the banking and financial services space.

The chart above depicts that, so far (for the period January 1, 2002 to October 17, 2011) the BSE Bankex has accelerated faster than the BSE Sensex, and even managed to outperform. Hence if one were to invest a sum of Rs 100 (on January 1, 2002) each in the BSE Bankex and BSE Sensex; the same today would have yielded a sum of Rs 1,113 and Rs 524 respectively (on October 17, 2011).

The outperformance of the BSE Bankex over the BSE Sensex, have not only helped banking and financial services sector funds to deliver appealing returns, but even outperformed the category of diversified equity mutual funds. Moreover, they have controlled their risk well (as revealed by the Standard Deviation), which in turn have helped them to strike an impressive risk-adjusted return (as revealed by the Sharpe Ratio).

By and large the equity diversified funds have been less volatile than the BSE BANKEX and the banking sector funds. But they have underperformed both - BSE BANKEX as well as banking funds, on the risk-adjusted return basis.

Some banking and financial services sector funds (managing assets over Rs 100 crore), have a significant exposure to index heavyweights such as ICICI Bank, SBI and HDFC Bank. However, a noteworthy point is, a limited spectrum of stock selection has made their portfolios rather concentrated (on an average they are holding 24 - 25 stocks in the portfolio). Top-10 holdings form as high as 78% in some funds (such as Religare Banking Fund), where the average exposure towards top 10 stocks (of all banking and financial services sector funds) has been around 70%.

So far, banking and financial service sector funds have not disappointed their investors. This success mainly attributes to:

• The buoyancy in the underlying theme (due to aforementioned fundamentals)
• Higher representation to the banking space in the broader indices
• Excellent performance of some index heavy banks
   

The road ahead...

Despite promising fundamentals of the sector (guided by policy framework), going forward banking and financial services sector stocks may remain under the pressures of anti-inflationary stance adopted by RBI if inflation continues to over the 9 % mark. Moreover, capital adequacy and the level of Non-Performing Assets (NPAs) are a major concern with the public sector banks off late. Also with rating agencies being vigilant and active on these issues, the risk of downgrades remains. Fragmented nature and intense competition in select geographies highlights the need to create new business models which would enable banks to capitalise on the huge unexploited market segment. Banks would have to increasingly balance the credit growth and the quality of assets. This in turn will reflect in the profitability of banks. Going forward, we might see a phase of consolidation in the banking and financial services domain which would facilitate the further growth of the sector. Capital intensive sectors such as infrastructure would demand more loan capital; banks and other financial institutions may have to play a key role in providing much needed credit to the sector. Striking the balance between social development and the asset quality would be imperative for further growth.

Moreover, though technology has been an enabler in the banking and financial services space, benefits of technological advancements have not reached to common retail customers in rural areas as yet.

India, to sustain the GDP growth of 8%+ would need a much stronger banking sector in terms of inclusion, efficiency and performance. This throws immense opportunities for the investors to benefit from the potential growth of banking and financial services sector.

What investors should do??

Though banking and financial services sector funds have accelerated on generating superior risk adjusted returns until now, they suffer from the risk of portfolio concentration as a single stock accounts for as high as 22% of the equity portfolio in some cases. Some banking and financial services sector funds have proved to be more volatile than the pure diversified equity funds which make some of them a high risk proposition. As far as the returns are concerned, their fortunes are closely linked to the performance of banking sector.

We believe investors would be better-off by investing in diversified equity funds as the benefit of diversification enables you to reduce the risk of the portfolio. Moreover, diversified equity funds too can help you tap investment opportunities in the banking and financial services theme, along with the other promising themes as well. But while investing we recommend you investors to invest those funds which have a minimum 3 year track record, and prefer fund houses which follow strong investment processes and systems. Moreover, while investing in diversified equity funds have a time horizon of 3 to 5 years.