If you see the composition of the S&P BSE Sensex in March 2006, out of the 30 constituent stocks, 21 have remained in the index over 10 years while the rest have been replaced. This means 30% of the index has changed. Similarly, Nifty 50 has seen around 30% stocks change over the past 10 years. Why do stocks get replaced in an index, and should it matter to you?

An index is a basket of securities that represents a specific section of the capital market. For example, S&P BSE Sensex and Nifty 50 represent the largest (by market capitalisation) and most liquid stocks in the domestic equity market. Whereas, S&P BSE Mid cap index and Nifty Mid cap index represent a set of medium-sized stocks.

Changes in indices take place to keep the selection relevant to the underlying description and also on account of corporate actions like mergers and acquisitions, and new listings. While individual stocks might change in terms of market cap or liquidity, the profile of an entire index should ideally remain within the originally stated objectives. Many indices are also used as benchmarks for privately managed funds and that's also why their composition has to remain relevant.

If changes take place too frequently, it's a cause for concern; at the same time, some changes have to take place.

Regular evaluation

Typically, index compositions are reviewed at pre-defined frequencies. In case of indices on BSE and NSE, this is biannual.

Care has to be taken that the reviews are not too frequent so that short-term variations don't upset the selection. The reviews shouldn't be too far apart either as that might mean irrelevant stocks being part of the index.

Each index has its own objective and is designed to measure the performance of securities that qualify for membership as per the index methodology. The index is reviewed twice a year, in June and December. This helps in identifying any outliers and also avoids frequent additions or deletions to the index due to short-term up or down movements of individual securities in the indices.

However, in some cases, more frequent reviews may be needed. While review frequency is six months for most indices, for specialised indices, like Nifty High Beta 50 Index and Nifty Low Volatility 50 Index, it is quarterly, a wholly owned subsidiary of NSE that is responsible for construction and maintenance of indices.

Indices have their own rules for stock selection and no two have the same rules.

Here is what you are dealing with when it comes to changes (replacements). For Nifty 50 there were 37 changes and 81 for Nifty 100 in the past 10 years. For Sensex, there were 20 changes and 88 for S&P BSE 100 in the same period. Among global indices, Dow Jones Industrial average Index, a 30-stock index, has seen 16 changes since 2006.

Changes also happen when a company gets acquired by another or is demerged from a parent. You need to watch out for these if you own such a stock. In fact, mergers and acquisitions have been cited as the main reason behind changes in the US-based S&P 500 index.

 

Impact on mutual funds

Index changes matter the most for passively managed funds such as index funds and exchange-traded funds (ETFs) whose portfolios mimic the underlying index. If a stock is replaced by another in the index, there is an immediate cost of transaction to effect this change. These funds also have to deal with the probability of higher impact cost of the replacement. "The change in an index happens as per the closing price. Though we may be able to capture a price close to it, there is low probability of getting exactly same price. This develops a tracking error for the fund

The price of a stock that is being replaced often declines during the run-up to the day. The opposite happens to a stock that is going to get included. The transaction needs to be managed in such a way that the tracking error is minimised; being able to avoid it completely is unlikely. Tracking error measures the difference in an ETF's performance compared to the underlying index. Globally, experts suggest a tracking error of 20 basis points (not including other fund expenses) as reasonable. One basis point is one hundredth of a percentage point.

There could be other issues in adding new stocks. The new stock has to be added proportionate to its allocated weight in the index. Let's say the new stock is 0.5% of the index but comes with a high market price of Rs.15,000. For an ETF basket with a value of Rs.25 lakh this is a problem, as 0.5% means Rs.12,500, and to accommodate a stock with a unit market price of Rs.15,000, the basket size needs to be increased to Rs.32 lakh.

This also means more cost as other stocks need to be bought proportionately to increase the basket size. The tracking error for a passive fund around the time of such changes is likely to be above the historical average.

On the other hand, for active fund managers such changes don't hold much consequence, unless the portfolio is benchmark hugging. In that case, it might be better for investors to invest in lower-expense passive funds. Some active funds, mostly large-cap-oriented ones, have a portion of the portfolio benchmarked. But for diversified funds, with at least 40-45 stocks, removal or addition of one stock in an index is not likely to make a material difference.

Intuitively, the tendency is to take a re-at look whether we hold the stock whenever there is an announcement regarding a change in an index. However, usually the portfolio weights involved are low and the change is not material.

Also, usually, stocks with high weights in an index don't move out suddenly. So funds with benchmarked portfolios may not have high exposure.

In general, the changes in index constituents aren't too many and the new stocks aren't the largest. The impact on a large-cap diversified (active) fund isn't much. It matters more for foreign funds, as they track index stocks closely since the top 30-50 stocks are the way to capture growth in an economy where they are not based.

But every once in a while, big changes do happen where a strong impact is felt. The Satyam debacle in 2009, for example. The stock that was part of Sensex and Nifty, crashed around 80% in a single day, which led to the benchmark indices losing around 6%.

Impact on benchmarking

Popular indices are used as benchmarks for actively managed funds and portfolios. This means that performance of such funds is compared with that of the benchmark. Some argue about the accuracy of the comparison if the constituents of the underlying index keep changing.

But what is important is that the characteristics of the index remains true to its original construct. After all, portfolios of the active funds too keep changing. In the Indian context, as the economic contribution from industries changes, the large-cap indices need to change as well to reflect this shift.

Sometimes, changes in indices over extended periods, say, 3-5 years, can add up to make the overall index move away from its earlier characteristics. Benchmarked funds also end up following this path.

Changes in the index over a period of time alter the nature of the index itself. At present, for example, with many metal and public sector banking stocks in large-cap indices being replaced by consumption-based and FMCG (fast-moving consumer goods) stocks, the nature of the benchmark index is turning defensive.

If you think of active funds as a selection of stocks based on fundamental attributes, ideally they could be seen as absolute return portfolios rather than have their returns compared with a mathematically derived index.

But for investors, comparing against the index is the reason they pay extra to the fund manager, and some base level performance hurdle (which an index provides) is needed even to structure fund portfolios.

Ultimately, for large-cap funds, indices make sense given that the index tries to capture the top stocks that reflect the state of the economy. And this is consistent with the mandate of most large-cap funds. In case of mid-cap and diversified funds, over time, deviation from underlying index is high.

Funds are required to have a benchmark by regulation. Fund managers have different styles and if one runs a benchmark-hugging portfolio then yes, changes will matter. On the other hand, a bottom-up style of stock selection does not get impacted by such changes.

There is merit in analysing the correlation between fund returns and benchmark returns, rather than looking only at performance against benchmark. This will help you ascertain return expectations and choose products based on whether you prefer funds where returns follow the broad markets or those focused on absolute returns based on stock selection.

Mint Money take

Stocks that get added to popular indices draw more interest by virtue of demand increasing as benchmarked portfolios get aligned. The opposite can happen when a stock is removed. But a long-term impact of this on stock price is debatable. Where more passive funds are linked to an index, the changes tend to have a greater impact on the market and the funds. The Indian equity market is much more actively managed marketani.

Effectiveness of an index is in remaining relevant to its characteristics. Large-cap indices have a higher burden as they tend to be reflective of the state of affairs in an economy.

While traders and foreign investors need to be cognizant about what's in and what's out of an index, for individual investors, basics don't change—pick quality stocks or consistently well performing mutual funds, and stay invested.