The Hindu Business Line : Chasing index returns

A growth economy is likely to benefit a large number of companies than the narrow basket the Sensex represents. So, restricting your investments to the index alone may mean missing several promising opportunities.

The Sensex has proved a tough benchmark to beat.

Shanthi Venkataraman

You see the index values rising daily to new highs. Yet the return on the stocks you hold in your portfolio looks relatively modest. This is despite following every rule in the investment handbook, be it doing your homework, diversifying your portfolio, or buying into undervalued stocks. If so, do not fret!

Professional fund managers may well share your angst. Apparently, following the rules did not pay off in the last year. Not if you measure yourself to the performance of the benchmark indices. Many equity fund managers struggled to beat the Sensex and the Nifty last year. In fact, holding a few stocks that make up the key weights in the index may have delivered far better results last year than holding a portfolio of many stocks.

Chasing index returns

One reason why your portfolio could have struggled to match the Sensex or the Nifty is the highly selective nature of the recent rally. The Sensex has gained 38 per cent in 2007. Yet only about 10 stocks within this basket have generated returns greater than the index; clear evidence that gains were driven by just a few stocks. Only a handful of stocks — Reliance Energy, Reliance, L&T, chief among them — have led the gains of the Sensex. Not only are these stocks among the top performers over the past year but they also have a significant weight in the index, contributing to the rise in the overall index levels. Even if you held mid or small-cap stocks, your portfolio wouldn’t have performed unless you held the handful of stocks that did well.

Testing the waters

If the recent stock price rally is all about the India story, why is it that only a handful of stocks have notched up much of the returns? Well, that is because foreign investors testing the waters in India tend to automatically migrate to the most visible names of India Inc. As a result, a huge body of inflows has been directed towards the index stocks by foreign investors who wish to buy the India theme. While some of the more seasoned FIIs invest deeper in mid-cap and small-cap stocks, investors unfamiliar with the Indian markets might choose to stick to the familiar names because they offer higher liquidity and more predictable returns.

Tracking breadth

Ever wondered what reports on the markets refer to when they say the “breadth of the market was weak”? What this means is that although the Sensex and other indices closed the day with gains, not all stocks participated in the rally. The reason why going by the performance of the index can be deceiving is because of the way indices are constructed.

Indices are meant to capture the essence of the entire market activity. Yet Indian indices don’t always do so, because of the manner in which they are constructed. To be included in the Sensex or Nifty, stocks need to meet market capitalisation and liquidity criteria.

While the indices attempt to provide a wide industry representation, the strict criteria have invariably led to a concentration of holdings within a particular sector. For instance, the Sensex has a heavy weightage (about 40 per cent) in finance and oil and gas sectors.

Because of this concentrated index construction, companies from sectors in take-off mode, such as media, retail, brokerages, logistics and construction, barely make an appearance in the Sensex or Nifty. The Sensex covers only 30 stocks after all, out of more than 7,000 listed companies.

Index changes

If you are chasing index returns, keeping an eye on its changing composition is also necessary. The frequent changes in composition in the indices over the past year have made a big difference to how the Sensex or Nifty fared. For instance, over the past year, the likes of Unitech, NTPC, Reliance Petroleum and Reliance Communication have been included in the Nifty, while stocks such as Jet Airways and Tata Tea, which had a tendency to lag, were shown the exit.

The Nifty, after a long period of trailing the Sensex, has finally caught up with the latter over the past year through these changes. The BSE, for its part, has introduced DLF into the Sensex, recognising the emergence of real-estate development as a significant sector.

Interestingly, keeping track of these changes might help you spot ideas that you can incorporate into your own portfolio. The mere announcement of the inclusion of a stock into either of these indices often sparks off buying in that particular stock. For instance, Unitech rose almost 30 per cent in the month running up to its inclusion in the Nifty.

Does index investing pay?

If the indices are so hard to beat, should one just stick to investing in the basket of index stocks? Index funds and exchange traded funds allow you to replicate the bellwether indices with little effort. But you probably shouldn’t get too carried away by what has happened over the past year or two, as this might only be a temporary phenomenon.

Diversified equity funds in India have traditionally delivered significantly superior returns by investing in stocks outside the indices.

Moreover, prudent investing practices, such as limiting their exposure to sectors and stocks, has helped them contain declines better than the indices during sudden market meltdowns.

A growth economy is likely to benefit a far greater number of companies than the narrow basket the Sensex represents. So, restricting your investments to the index alone may not only result in a concentrated portfolio but may also mean missing several promising opportunities. This is especially true if you are building a portfolio for a five-ten year period.

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