Some experts are making bullish predictions about the future of the Indian banking sector despite it being saddled with NPAs, frauds, and other share of problems.

The underperformance of Nifty 50 as against Nifty Bank Index denotes that only a handful of financial stocks have driven both the indices. If you exclude them, the performance of Nifty 50 would’ve been much worse.

What went wrong with the equity markets in 2018?

To begin with, government imposing the capital gain tax on long-term capital gains made on equity shares and equity mutual funds, dampened sentiments. Global factors such as increasing crude oil prices, rising US Dollar, interest rates normalisation in the U.S., and worsening trade relations between the U.S. and China knocked out emerging equity markets.

The financial sector had an even tougher time

RBI hiked policy rates twice, causing hardening of yields. Rising yields often push the borrowing cost for banks and Non-Banking Financial Companies (NBFCs) higher. To add to their worries, the default by the subsidiaries of IL&FS rocked the financial sector in September. As a result, there was a massive selling in the NBFCs and some private sector banks.

As you might be aware, Public Sector Banks (PSBs) have been reeling under pressure for almost 6-7 years. At the end of every year, you hear about them reaching the tail end of the Non-Performing Assets (NPA) conundrum.

With Punjab National Bank (PNB) opening a can of worms by reporting the Nirav Modi scam, problems of PSBs appeared far from over. In fact, 11 banks out of 21 listed PSBs are under RBI’s Prompt Corrective Action (PCA) framework as of now.

Once a bank is brought under the PCA framework, it has to reduce exposure to risky and unrated assets, it can’t freely expand its branches, has to pay dividends, raise money by selling non-core assets, and chart out a recovery plan. In fact, the government has been feuding with RBI over the issue of the PCA. It wants RBI to relax the PCA norms to support economic growth.

The government has hinted at a major consolidation in PSBs by announcing the merger of Bank of Baroda, Dena Bank, and Vijaya Bank. But, the market doesn’t seem to be impressed much with this effort.

As we are approaching the end of 2018, there are still no takers for PSBs in the stock market. The newly appointed RBI governor, Mr Shaktikanta Das may have to take stringent measures to reinforce RBI’s credibility and autonomy. What he decides for PSBs remains crucial.

Not everything’s well with Private sector lenders…

As far as private sector banks are concerned, three of them are seeing a change in the top positions, perhaps for the wrong reasons. Recent events have given rise to doubts about corporate governance in some of the private sector banks. It remains to be seen how long private sector banks enjoy the valuation premium going forward.

After posting a massive growth over the last few years, NBFCs are bogged down with liquidity issues and the overheating of balance sheets. Some mutual funds have sold credit instruments issued by NBFCs at a steep discount. This has been a red flag.

[Read: DSP Mutual Fund's Sale of DHFL Bonds: Here's What You Need to Know] 

Are we in for big trouble? That’s the question many investors are asking.

Despite all these developments, the general tone in the market about the potential of India’s banking sector appears optimistic at the moment. Higher credit growth experienced lately is giving further rise to the expectations of investors.

You can sense this optimism in Mr Sukumar Rajah’s outlook. He is of the view, “If you take a 10-year view, currently the private sector banks' market share is 30 per cent. Probably it will become 60 per cent”. He also forecasts, “The overall health of the banking system will improve because the better banks will be a bigger portion of the market and the weaker banks will become a smaller portion of the market”. Mr Rajah serves as the Managing Director (MD) and Chief Investment Officer (CIO) of Equity and Portfolio Manager at Franklin Templeton Asset Management (India) Private Limited.

Is this optimism warranted?

The answer is no!

Should you invest in banking and financial services sector?

Again, the answer is no.

Table 1: Banking sector funds underperformed – Not so good to bank on

	Absolute Returns (%)		CAGR Returns (%)
	YTD	1 Year	3 Years	5 Years
Average returns generated by banking and financial services funds	-1.2	-0.1	17.1	19.8
NIFTY BANK - TRI	6.2	6.6	18.1	20.1

Data as on December 17, 2018
(Source: ACE MF)

At a time when only a handful of banks and NBFCs are managing to stay in shipshape, the majority of banking and financial services sector funds are struggling to beat the Nifty Bank-TRI. That’s why PersonalFN believes, you can’t bank on them.

Timing the entry and exit in sector funds is crucial to make handsome gains. And, timing the market is possible only if you’re superhuman. So you could bet on sector funds if you think you are one. The others should avoid investing in sector funds.

Most considered the banking and financial services sector the proxy on India’s economic progress. Undoubtedly it is, since India is the fastest growing economy in the world, and many investors are enthused. But let’s not forget, the financial sector in India, of late, is encountering its own share of problems and can expose investors to high volatility if something goes wrong.

Instead, bank on diversified equity mutual funds…

Diversified equity mutual funds are the best option if you want to benefit from the prospects of the financial sector. On an average, diversified mutual fund schemes have approximately 26.4% exposure to banking and financial services sector, as per portfolios disclosed on November 30, 2018. Invest in them through Systematic Investment Plans (SIPs) and prefer direct plans.

Adopt core and satellite approach to generate superior returns…

Under the uncertain market conditions, which exist today, following the core and satellite approach while investing in mutual fund investing would prove far more sensible than betting on sector funds.

[Read: Turbulence Ahead! Here’s an Investment Strategy You Need To Follow]

The ‘Core and satellite’ investing is a time-tested strategy to build your investment portfolio. For the mutual fund investors, the ‘core portfolio’ should consist of large-cap, multi-cap, and value funds, and the ‘satellite portfolio’ should include mid-and-small cap funds and opportunities style funds. 

Editor’s note:

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In this report, PersonalFN will provide you with a ready-made portfolio of its top equity mutual funds schemes for 2025 that have the ability to generate lucrative returns over the long term. Subscribe now! 

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