Using Bank ETFs for Strategic Positioning in Portfolio

In any economy, banks play a crucial role by facilitating the flow of funds between savers and borrowers, promoting investment and economic growth and contributes to the stability of the financial system through regulation and risk management framework. With nearly a year of static rate regime, it is widely expected that interest rate cuts are around the corner. Financial sector as a whole typically responds positively to interest rate cuts due to their impact on borrowing costs, economic activity, asset prices, refinancing opportunities, and investor sentiment.

Lower interest rates

To begin with, lower interest rates reduce the cost of borrowing for financial institutions. It becomes cheaper for banks to borrow money from the RBI. This allows banks to offer loans and mortgages at lower interest rates to consumers and businesses. As a result, there is an increase in borrowing and spending, which drives demand for financial products and services such as loans, mortgages, and credit lines.

Second, interest rate cuts stimulate economic activity by encouraging borrowing and investment. Lower interest rates incentivize businesses to increase capital expenditures, consumers to boost spending, and investors to engage in investment activity. This heightened economic activity translates into higher demand for financial services, including lending, investment management, and advisory services.

Cheaper borrowing

Third, lower interest rates lead to a boost in asset prices. When interest rates are lowered, borrowing becomes cheaper, prompting increased demand for assets such as real estate and stocks. Financial institutions benefit from higher asset prices as they earn fees from managing investment portfolios, providing brokerage services, and facilitating transactions in these markets.

Fourth, interest rate cuts create opportunities for refinancing existing loans at more favorable terms. Homeowners and businesses can take advantage of lower interest rates to refinance their loans, resulting in increased business for banks and mortgage lenders. Financial advisory services also see heightened demand as individuals seek advice on refinancing options and navigating the changing interest rate environment.

Investor sentiment

Fifth, interest rate cuts improve investor sentiment by signalling central banks’ commitment to supporting economic growth. Investors interpret interest rate cuts as a positive indication of future economic prospects, leading to increased confidence in financial markets. This can result in higher investment activity, particularly in financial services stocks and related sectors.

Positive reaction

In effect, financial sector as a whole tends to react positively to interest rate cuts. Given the cascading effect of rate cuts, when central bank cuts interest rates, it affects the stock market, too.

To understand the impact, let us consider the Nifty Bank price return index (PRI). The PRI index does not include dividends. If we consider the rate cuts over the past two decade (March 2004 and March 2024), there were 21 instances of a rate cut and the index showed an average return of 34% after 1 year, 18% per year on average after 3 years, and 13% per year on average after 5 years. For example, if you invested Rs 1 lakh on the announcement day, it would have grown to Rs 1.34 lakh after 1 year, Rs 1.63 lakh after 3 years, and Rs 1.86 lakh after 5 years. Interestingly, if the rate cut is more than 50 basis points (0.50%), returns are higher after 1 year. If the quantum of rate cut is lower, returns after 3 years are better, though there might be more ups and downs in the first year.
Nifty Bank Index

One of the ways to take exposure to the banking sector passively is by investing in Bank ETFs. The underlying index here could be the Nifty Bank index. By investing in such an ETF, an investor will gain exposure to the overall health and performance of the banking industry.

The Nifty Bank index includes most of the biggest and most traded banking stocks in the country. Hence, this index is used as a barometer to gauge the performance of the banking sector as a whole in the stock market. The index comprises of top 12 banks in the country, all of which are a part of the Nifty 500 universe. No single stock in the index will have a weightage of more than 33% and the total share of the top three banks at any point will not be more than 62%. The index is rebalanced every January and July.

Furthermore, if an investor seeks to take exposure only to PSU banks or private banks, then there are ETF offerings based on the Nifty Private Bank Index and the Nifty PSU Bank Index. So, basis one’s portfolio or tactical positioning requirements, investors can consider between either of the three ETF offerings.

To conclude, as central banks continue to adjust monetary policy in response to economic conditions, investors can benefit from the changing landscape of the rate cut journey by investing through bank ETFs.

The author is Principal -Investment Strategy, ICICI Prudential AMC. Views are personal.