Your Questions Answered: What are banking and financial service sectoral funds and its pros and cons?

Q. I am an engineer working with the Indian Railways, currently posted in Hubli. My wife works with a digital marketing agency remotely. We have been investing in Nifty and Sensex tracking mutual funds for the past 5 years. We now wish to diversify our portfolio and invest in sectoral funds. Many of our acquaintances have suggested investing in mutual funds investing in the banking and financial services sector. However, we have limited knowledge about the same. Can you please elaborate on what are banking and financial service sectoral funds and the pros and cons of investing in these?

J. Nagmani, Hubli, Karnataka

Understanding sectoral funds

Before we understand what banking and financial services funds are it is important to understand what sectoral funds are. In the diverse world of investment, mutual funds have carved out a niche for themselves, offering a plethora of options for investors with varying risk appetites and market interests. Among these options, sectoral funds stand out as a unique choice for those looking to capitalise on the potential of specific sectors of the economy.

Sectoral funds are a type of equity fund that concentrates their investments in a particular sector of the market, such as technology, healthcare, or finance. By focusing on a single sector, these funds aim to leverage the growth potential of that sector, which can lead to higher returns compared to diversified funds during periods of sectoral growth. However, this focus also means that sectoral funds can be riskier, as they are more susceptible to the fluctuations and downturns of their chosen sector.

The rationale behind investing in sectoral funds is the belief in the growth story of a particular sector. For instance, an investor who believes that the IT sector will outperform the broader market due to advancements in artificial intelligence and machine learning might choose to invest in an IT sectoral fund. This allows the investor to potentially benefit from the growth of the sector without having to pick individual stocks.

One of the key advantages of sectoral funds is the expertise of fund managers who have a deep understanding of the specific sector and can make informed investment decisions. These fund managers track the performance and prospects of companies within the sector, adjusting the fund's portfolio to maximise returns. However, the concentrated nature of sectoral funds also brings with it a higher level of risk.

Since the fund's performance is tied to the fortunes of a single sector, any adverse events or downturns in that sector can significantly impact the fund's returns. Therefore, sectoral funds are generally recommended for investors who have a high-risk tolerance and a thorough understanding of the sector in which they are investing. 

Sectoral funds offer a way for investors to gain exposure to specific sectors they believe will outperform the market. With the potential for high returns comes higher risk, making these funds suitable for knowledgeable investors with a clear strategy and a diversified portfolio. As with any investment, it's crucial to conduct thorough research and consult with financial advisors to ensure that sectoral funds align with one's investment goals and risk tolerance.

What are banking and financial services funds?

Banking and financial services funds are sector-specific funds that predominantly invest in equities and equity-related instruments of companies in the banking and financial services sector. This includes a wide array of institutions such as banks, non-banking financial companies (NBFCs), insurance companies, housing finance companies, stock brokers, depositories, stock & commodity exchanges, and other financial entities.

Investors are drawn to banking and financial services funds for several reasons. Firstly, the banking sector is considered the backbone of the Indian economy, playing a crucial role in economic growth and development. 

Secondly, the financial services sector is on a growth trajectory, driven by increasing financial inclusion, digitalisation, and supportive regulatory policies. These factors contribute to the potential for robust growth in the sector, making it an attractive proposition for investors seeking to capitalise on the sector's performance.

Performance and risks

The performance of banking and financial services funds is closely tied to the economic cycles and interest rate movements. During periods of economic prosperity and falling interest rates, these funds tend to perform well as they benefit from increased lending, lower non-performing assets (NPAs), and expanding profit margins. 

Conversely, during economic downturns or when interest rates rise, these funds may face challenges due to the pressure on margins and an increase in NPAs. It's important for investors to understand that sector funds, including those focused on banking and financial services, carry a higher risk compared to diversified equity funds. This is due to their concentrated exposure to a single sector, which can be volatile and subject to regulatory changes.

Performance and returns

Several mutual funds in India specialise in the banking and financial services sector, offering investors an opportunity to partake in the growth of this dynamic sector. Here are the top 5 banking and financial services sector mutual funds (direct schemes) ranked based on their 3-year performance.

Source: AMFI website; data as of 7 November 2024

Note:Past performance is not an indication of future returns.

Investment strategy

For investors considering banking and financial services mutual funds, a long-term investment horizon is advisable. Given the volatility and cyclical nature of the sector, these funds are best suited for investors with a high-risk appetite and an investment timeframe of at least 5-7 years. It's also prudent for investors to limit their exposure to sector funds as part of a diversified investment portfolio.

Pros and cons of investing in the banking and financial services sector

Pros

Among the various categories of mutual funds, the banking and financial services sector funds stand out for their unique characteristics and potential benefits to investors. Here's a detailed exploration of the advantages of investing in banking and financial services funds in India.

• Diversification within a sector: Banking and financial services funds offer investors an opportunity to gain exposure to a wide array of financial institutions, including banks, NBFCs, insurance companies, and other financial entities. This diversification within a sector can potentially reduce risk while still allowing investors to capitalise on the growth of the financial sector.
• Professional management: Investors benefit from the expertise of seasoned fund managers who have a deep understanding of the banking and financial sector. These professionals are adept at analysing financial statements, assessing market conditions, and making informed decisions to steer the fund toward favourable outcomes.
• Growth potential: The Indian banking sector has shown resilience and growth potential, driven by increasing consumer demand, technological advancements, and supportive regulatory frameworks. Investing in this sector through mutual funds allows investors to partake in the potential upside as the sector expands.
• Liquidity: Mutual funds offer the advantage of liquidity, allowing investors to redeem their units at any point, subject to exit load, if applicable. This provides a level of flexibility that is particularly valuable in times of financial need or when market conditions change.
• Rupee cost averaging: Investing in mutual funds through Systematic Investment Plans (SIPs) enables investors to benefit from rupee cost averaging. This strategy involves investing a fixed amount regularly, which can lead to purchasing more units when prices are low and fewer units when prices are high, potentially lowering the average cost per unit over time.
• Alignment with financial goals: Banking and financial services mutual funds can be aligned with an investor's long-term financial goals, such as retirement planning or wealth creation. The potential for higher returns compared to traditional savings instruments makes them an attractive option for goal-based investing.

While the advantages are compelling, it's important for investors to consider their own risk tolerance, investment horizon, and financial goals before investing in banking and financial services funds. The sector-specific focus does carry a higher risk compared to more diversified funds, and investors should be prepared for the volatility associated with the financial markets.

Cons

When it comes to sector-specific funds, such as those focusing on banking and financial services, investors should be aware of the unique set of challenges they may face such as the ones enumerated below:

• High costs: One of the primary concerns for investors in banking and financial services funds is the associated costs in comparison to passive funds. These funds often come with high expense ratios due to active management and other operational expenses.
• Concentration risk: Banking and financial services funds are inherently more concentrated than diversified mutual funds since they invest heavily in a single sector. This concentration can lead to higher volatility and risk, especially if the sector faces economic challenges. During times of financial downturns, these funds may experience significant losses.
• Market sensitivity: The banking and financial services sector is highly sensitive to market fluctuations and regulatory changes. Interest rate movements, policy shifts, and economic cycles can all have a profound impact on the performance of these funds. Investors must be prepared for the possibility of short-term losses due to these factors.

How are they taxed?

Budget 2024 brought significant changes to the taxation landscape, particularly impacting capital gains, mutual funds, and gold investments. The long-term capital gains tax on equity-oriented investments including banking and financial services funds has been increased from 10% to 12.5%. Moreover, the short-term capital gains tax on the same category of mutual funds has risen from 15% to 20%.

Conclusion

Banking and financial services funds offer a gateway to participate in the growth of a pivotal sector in the Indian economy. While the potential for high returns is an attractive feature, investors must exercise due diligence and consider their risk tolerance, investment goals, and time horizon before investing. 

With the guidance of professional fund managers and the benefits of diversification, liquidity, and tax efficiency, these funds can be a valuable addition to an investor's portfolio. However, like all investments, they should be approached with due diligence and an understanding of the associated risks.

Kuvera is a free direct mutual fund investing platform. Unless otherwise stated data sourced from BSE, NSE and kuvera.