Nifty index weights skew returns

In the last 12 months, the Nifty has returned 15 per cent in rupee terms, with the breakout of the last month having resulted in 3 per cent gains. In dollar terms, the returns in the past year amount to about 3 per cent.

By any standards, that's a big bull market. Or is it? Some experienced long-term investors who hold large-cap portfolios anchored to the Nifty have lost money. This is despite being buy-and hold players, who have not made the classic mistakes of churning, or blindly chasing momentum.

The paradox of a bull run which hasn’t rewarded investors holding portfolios similar to the Nifty is due to the quirk of index construction. The Nifty is a free-float weighted index, where stocks are weighted according to percentages held by non-promoters. This creates a bias in favour of the gainers.

Stocks that outperform the index, gain in weight, as well as price. The weight decreases for stocks that underperform. The influence of a gaining stock is therefore, magnified, while the influence of a losing stock is reduced.

The Nifty has seen a fairly broad bull-run with 29 out of the 50 stocks having positive returns in the last year.  But a handful of stocks, just five of the 50, have contributed the lion’s share of the gains because those five giants hold roughly one-third the weight of the index.

Some of other 24 winners have also made apparently significant gains. But their contribution to the index move is less because these have relatively low weights. Meanwhile, 21 stocks have lost ground but their weight has also reduced and therefore, their losses have not affected the index much.

The paradox is easier to understand, if we look at returns since the last major market peak in late January in the run up till the Budget. The Nifty hit 11,170 in pre-Budget trading and many investors bought around that time, in the hope of a decent Budget.

The index has since gained 5 per cent in rupee terms, hitting a high of 11,760. In terms, the returns since January 30, have been negative at minus 8 per cent, due to the weaker rupee. Only 23 stocks have gained (in rupee terms) in the recent rally, while only 27 have either stayed stable or lost ground since budget. If the Nifty had been equally weighted, the returns since January would have been negative.  

The “Super Five” that have given major impetus since the Budget are Reliance Industries (RIL) (up 27 per cent), HDFC Bank (up 2 per cent), Infosys (up 27 per cent), ITC (up 14 per cent) and TCS (up 34 per cent). These five contribute 35 per cent of the Nifty’s weight.

Over the past year, TCS (up 68 per cent) and RIL (up 49 per cent) have contributed the most with Infy (up 63 per cent) also being a big contributor. HDFC Bank has contributed 17 per cent, keeping pace with the Nifty, while ITC has underperformed and seen reduced weight, with a 10 per cent contribution.

Meanwhile stocks like IOC (-30 per cent), HPCL (-49 per cent) Tata Motors (-34 per cent), BPCL (-35 per cent) and Vedanta (-28 per cent), have all lost ground in the last year. But these five big losers are low-weight stocks, contributing less than 3.4 per cent weight to the index.

Understanding how the weights bias index returns has important implications for active and passive investors. Even if you hold a large cap portfolio that seems to mirror the Nifty, you may get a return that varies wildly from the index return.