Banking Funds Underperforming – Should You Invest or Avoid?

Last Updated : June 12, 2020, 6:11 p.m.

Banking funds are a type of sector funds that invest in banking stocks. So, a banking fund portfolio would have names such as SBI, ICICI, SBI, Kotak, Bank of Baroda, etc. As per the mandate, these funds cannot invest in any other sector except banking. There is a flexibility to invest in large, mid, or small-cap banking stocks. For e.g.- SBI is a large-cap stock having a large market capitalization whereas Federal Bank is a small-cap stock having a smaller market capitalization. These funds also keep on changing weightages among banking stocks basis the fund managers’ view on which among the banks are most likely to do well. These funds are benchmarked against the Nifty Bank index.

Top Mutual Funds to Invest in Now

Banks are an integral part of the economy and are like fuel for the engine. Without banks, economic growth is not possible since they are the largest lending entity in the world. Whether it is a small company or a large corporate, they rely on banks to fund their growth plans. The health of banks has a direct correlation with the performance of banking funds. Over the last few years, owing to various factors, banks have been under a lot of strain which is showing up on the performance of banking funds. Let us compare the returns (in % terms) from banking funds against other major sector funds. We have taken the four largest sectors in India.

Source – Value Research

These returns are the average of all funds in the respective sector. There would be individual funds that would be outperforming or underperforming this category average, but mostly returns would be in the vicinity.

This data shows the massive underperformance of banking funds vs other sector funds. The underperformance is glaring in the last one year specifically where banking funds have eroded wealth by 33%. Banking stocks have been the worst hit in the fall in stock markets due to COVID-19 which has eroded the past returns as well. On a 10 year basis, which is a fairly long term period, banking funds have returned a meagre 4% which is equivalent to the return from a savings bank a/c whereas all other sectors have delivered double-digit returns despite of the recent market fall. But why has this happened? Why are banking funds doing so badly? We can understand by looking at the factors that have been plaguing the banking industry in the past many years.

Reasons for Underperformance

High NPAs – Banks have been saddled with huge NPAs largely on the corporate loan book. There have been many write-offs and defaults, essentially money which banks had lent but could not recover. Companies such as Jet airways, ADAG, DHFL, Essel group, Videocon, Kingfisher have been among the corporates who have gone bust and have been unable to repay. This surge of NPAs has been a double whammy- profits of banks have fallen and they are reluctant to lend aggressively. Thus, they are currently caught in a vicious cycle.

Lack of Credit Growth – Banking is a very simple business, banks get money as deposits and lend as credit. The difference is the return which they make. For e.g.- if the bank gives an account holder 4% interest on savings a/c and further lends that money as a loan at 8%, it makes 4% as its profit after adjusting costs. Credit growth has been falling for the last 5-6 years due to a lack of demand since not many companies have been expanding rapidly. The NPA mess has also led to banks being circumspect to lend. Unless this demand-supply equation normalizes and credit picks up, banks’ profitability will be under strain which has a direct impact on the stock prices.

Negative Sentiment – There has been a negative sentiment in the investing community and public at large due to various scams that have taken place in some banks. Cases like the Nirav Modi scam in PNB or the downfall of Yes Bank have led to fear among investors on the stability of some banks leading to a fall in prices.

Better Opportunities – Investors have rotated their allocation in banks to other performing sectors such as pharma and consumption, leading to a sell-off in banking stocks which is evident in the returns delivered by banking funds.

Future Outlook – Markets are forward looking machines that discount the future. Owing to COVID-19, the RBI has declared a moratorium on EMIs which will have an adverse impact on the banks’ asset-liability ratios and make them even more cautious in lending. The first wave of NPAs was led by corporate loans, there is a fear in the market that retail loans could now come under stress with larger write-offs and NPAs. This could be triggered by salary cuts and job losses due to COVID-19. Based on this outlook, banking stocks have seen heavy selling in the last three months.

Should You Invest or Avoid?

The next one year looks challenging for the banking sector because of the above factors. Credit growth is unlikely to pick up and NPAs from retail loans will increase. This would mean that banking stocks will remain under pressure and banking mutual funds will underperform. However, the sharp fall in banking stocks has made the valuations attractive for the sector. We would recommend you avoid banking mutual funds currently and wait for more clarity in the next couple of quarters on how the NPA & credit situation shapes up.