(This article was first published in The Economic Times.)
The government’s demonetisation drive has turned banking mutual funds into the flavour of the season. The equity banking fund category generated close to 20% returns in 2016.
The top-performing funds in this category earned even more than the category average. The banking indices—BSE Bankex and Nifty Bank—beat the broader market indices by considerable margins.
So, are you missing a trick by not having banking funds in your portfolio? Probably not. Here are two primary reasons why you should be wary about investing in banking funds, despite their exemplary performance in recent times.
Sector funds are volatile
According to data from Value Research, the same banking funds that returned around 20% in 2016 had posted negative returns in 2015. For instance, the top-performing banking fund for 2016 was ICICI Prudential Banking and Financial Services with 21.70% returns. But a year before that, it was in the red with -6.69% returns. The same is the case with its category peers.
No banking fund was in the green in 2015. Chasing their recent performance can be detrimental to your portfolio returns because no one can accurately anticipate the direction in which a particular sector will go. Investing in a banking fund right now amounts to timing the market, something long-term investors should avoid doing.
However, what about the fact that banking and financial services stocks are expected to benefit from demonetisation? That brings us to the second reason.
Diversified funds are investing in banking stocks
The diversified equity funds that you currently hold will already have sizeable exposure to banking and financial services stocks. We looked at the portfolios of the top performing diversified funds of 2016 from the large-cap, multi-cap and mid-cap categories, and found that the average allocation to financial services stocks among these funds is close to 20%.
These diversified equity funds also have banks and financial services companies among their top portfolio holdings. This means that if you’re investing in diversified funds, you’re already investing sufficiently in the financial sector. As this sector benefits from demonetisation, your diversified equity fund will benefit as well.
If you invest in banking funds separately, you will only make your portfolio overexposed to the banking and financial services sector. Dinesh Rohira, Founder and CEO of 5nance.com says, “Money has come into the banking system but their earnings will be affected till the surplus funds are deployed properly. Hence, concentrating your portfolio to this sector will increase your portfolio’s volatility.”
In a nutshell, banks and financial services companies will probably do well in 2017. But you shouldn’t invest in banking funds because your diversified equity funds are already investing in this sector. So continue investing in diversified funds and let the fund managers worry about taking sectoral calls. That’s what you pay fund management fees for.