When it comes to index investing, investors tend to wonder which is the better benchmark index to bet on – Sensex or Nifty.
The Sensex has 30 stocks, while the Nifty is composed of 50. The Sensex is the benchmark index of the Bombay Stock Exchange (BSE), while the Nifty is of the National Stock Exchange (NSE).
Both indices adopt the free-float market capitalization weighted methodology. The market capitalization of a company is calculated by taking the equity's price and multiplying it by the number of shares readily available in the market. The free-float methodology calculates the market capitalization of the index's underlying companies. This excludes locked-in shares, such as those held by company executives or promoters or the government.
Both indices act as a benchmark to measure the performance of the largest listed companies. So if you want a large-cap exposure to the market, how must you decide between the two?
While there are differences in the daily movement of the two indices, they are inconsequential. The reason being that a majority of the stocks that comprise the Nifty and the Sensex, tend to overlap.
The long-term trajectory for both tends to remain in sync. If you are a considering an investment horizon of, say, 10 years, it would make no difference as to which you pick. In the short term it is possible that one index might do slightly better than the other, but over the long term, it evens out.
When you invest in an index fund, the investments are made based on the weight of each company that comprises the index. For example, let’s say you invest ₹100 in an index fund. And that index has a weight of 11% to RIL, 8% to HDFC and 3% to L&T. That is how ₹22 will get invested. Your money will be invested according to the weight of each stock in the index constituent.
Logically, the narrower the index, the higher the risk of concentration. Given that when investing in index funds, the investors want to eliminate certain risks, such as picking the wrong stocks, it is safer to bet on an index that has more constituents.
If we follow that thought process, the Nifty is more diversified in terms of stocks and sectors. But in reality, both indices represent the weighted average of the largest Indian companies, and the top 20 companies have the most weight.
A look at data a few days ago revealed that the top three stocks of the Sensex (RIL, HDFC Bank, Infosys) have an exposure of 31.57%, while the top five stocks (add HDFC and ICICI Bank) took it to 47.29%. The bottom four stocks had an exposure of just 3.61% (NTPC, IndusInd Bank, Bajaj Auto, ONGC). So the diversification argument of Nifty 50 against Sensex 30 doesn’t really hold.
Financial adviser Dev Ashish warns that this concentration risk in indexes eventually gets replicated in the index fund portfolios. Here’s what he has to say:
The more concentrated an index, the higher is its vulnerability. The entire premise of having a well-diversified index is to spread one’s investment across various stocks and sector sufficiently well.
In India we have the Sensex and Nifty with 30 and 50 stocks, that too skewed towards a few. Index funds and ETFs that replicate these indices have a similar portfolio composition. Compare that to benchmark indices like the S&P 500 and Nasdaq that have diversified portfolios in 500 and 100 stocks, respectively.
The concentration risk is comparatively lower in actively managed funds. SEBI guidelines do not allow actively managed equity schemes to own more than 10% in a single stock. After this limit is hit, the weight of a stock in a scheme can go up only to the extent of the rise in its share price.
So unlike the index itself (and the passive funds/ETFs replicating it), an actively-managed fund won’t have bets that are too concentrated or make the portfolio uncomfortably risky.
I am not against passive investing, I am only highlighting the concentration risk which many are unaware of. If you find this disconcerting, you can follow a strategy of using a combination of actively and passively managed funds.
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