Putting indices to use
Apr 10 2017
Sectoral indices can come handy for lay investors in plotting a winning portfolio
The rest of the indices are often quoted in the media reports for comparisons, but have never got the desired traction in trading volumes. One reason for this is the absence of top-notch companies in these sectors or the indices. Though India has more listed companies than most other emerging markets, their distribution in most sectors is skewed in favour of a few. This virtually makes these indices representatives of a few large firms than an entire sector.
But investors can use this drawback of the indices intelligently to build a portfolio that could even outperform broader market indices.
The National Stock Exchange has 11 sectoral indices. If one picks the top two stocks from each index, a winning portfolio can be easily put together.
First, let us look at the benchmark Nifty 50 Index to know its return for comparison. In the last ten years, between March 30, 2007 and March 31, 2017, the index had clocked a compounded annual growth rate (CAGR) of 9.15 per cent.
Now let us see how the sectoral indices have done. Take the Nifty Auto Index. The two stocks with the highest weight on this index, as on March 31, 2017, are Tata Motors and Maruti Suzuki India. The Tata Motors stock had a CAGR of 12.83 per cent while the Maruti stock had a much higher growth rate of 22.05 per cent. Both have shown a growth rate higher than the main Nifty 50 Index’s.
On the Nifty FMCG Index, the top two are ITC and Hindustan Unilever. Their price performance is again extremely good, giving a return of 18.80 per cent and 16. 09 per cent, respectively.
The top two stocks on the Nifty IT Index are TCS and Infosys Technologies. Though IT stocks are underperforming of late, their CAGR over the last ten years comes to 14.72 per cent and 7.22 per cent, respectively, for the top two. Note that Infosys has under-performed the Nifty 50 Index. However, two points have to be noted here. One, the IT sector has passed its prime in valuation by 2007. Two, the combined growth of TCS and Infy would still beat the Nifty 50’s return for the period. Hence, one’s portfolio is not exactly underperforming here.
Then there are the Nifty Financial Services, Media, Metal, Pharma, Private Bank, Realty, PSU Bank, and Bank indices. One can add the top two stocks from some of these indices to the portfolio.
Care should be taken not to use any discretion in this stock-picking. Once the sector is chosen, even if the stocks are underperforming in the short-term, their weightage should not be altered to suit one’s gut feeling, or look for a substitute stock in the sector . What is meant by weightage here is that if one has decided to have 20 stocks, then each stock should be given a 5 per cent weightage, or in case only five sectors are chosen, then 10 per cent weight to be given to each index.
This discipline is important, because if the weightage is changed, based on any logic, the optimal return would not be obtained in the long-term, though it might give a higher return in the short-term.
However, if a stock is thrown out of an index, which is unlikely, that stock should be moved out of the portfolio. The only discretion one may take is in picking the sector to invest. Like, when it is obvious that metal and media sectors are unlikely to perform in the medium term, those sectors may be avoided until they outperform the broader market index for two to three quarters. If they outperform by a wide margin for two to three quarters, it can be assumed that the fundamentals have changed for the sector and it might outperform even for the long-term. But once a sector is included, it should stay in portfolio for a long time. Frequent churning of sectors would increase the subjective element in the decision and that is never desirable.
An investor trying to form this portfolio would face a problem, rather confusion, in selecting the stocks if there is an overlap of a stock in two indices. Let’s take the banking sector, which is represented by four related indices—the Nifty Financial Services Index, Nifty Bank Index, which has a mix of private and public sector banks, the Nifty PSU Bank Index and the Nifty Private Bank Index.
In Nifty Bank, Private Bank and Financial Services indices, HDFC Bank is a common constituent. In such cases, take the third stock from the index. For instance, from the Private Bank Index the third bank, Kotak Mahindra Bank, can be included.
Such a handpicked portfolio will have a definite advantage over plain vanilla exchange traded fund (ETF) as they would avoid some of the over-priced stocks on lazy ETFs. Evidence suggests that some stocks make their place in broader market indices, like the Nifty 50 and Sensex, when they are inching close to their record highs. This means that essentially, one is buying into such a stock through an ETF when one should ideally be exiting the stock.
Another benefit of devising one’s own portfolio is that when a corrective move sets in, one would be saved the brunt of a sharp fall as the top companies in most sectoral indices outperform the market even in a strong bearish phase.
So, start tracking sectoral indices and put them to some good work.
(Rajiv Nagpal is consulting editor, Financial Chronicle)