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Understanding recent changes to the BSE Sensex

As Indians get more comfortable with investing in equities we see large amounts of money being invested into Indian equities.  The most well-known representation of our market are the major indices – the BSE Sensex and the Nifty 50 Indices. Today let us take a closer look at the BSE Sensex and also how changes are being made to the index.

Some recent changes

Last week the BSE announced the latest changes to the Sensex which will be effective from 24thDec. Both changes are very interesting and worth examining:

  1. Wipro is being replaced by HCL. As pointed out by Livemint, this completes a full cycle!! In 2003 the BSE replaced HCL with Wipro and has reversed the decision 15 years later. Did Investors benefit from the original decision? The answer is a huge NO ! In these 15 years, HCL Tech shares have given four times higher returns than Wipro!! Yes, that is right – 4x the returns which Wipro gave.
  2. Adani Ports is being replaced by Bajaj Finance. With that the sector weightage for banks and financial services has increased to 41%. That is a very high concentration for one sector increasing overall sectoral risks.

Changes in the Past

  1. Let us look at what BSE did last November. They dropped Cipla and Lupin and added Yes Bank to the Index along with Indusind bank. As it is well known, Yes Bank has done extremely badly this year for various reasons. On the flip side, the pharma sector has begun to rally and dropping both the pharma names does not look like a great choice!
  2. In November 2015, the BSE dropped Hindalco when it was trading at 75 Rs. It is now trading at Rs 220 (up three times in three years). Similar to Pharma, the metal stock was removed at the bottom of the commodity cycle

Let us understand the diversification of the Sensex from other viewpoints

  • From a sector diversification viewpoint, the skew towards financial services is at an all-time high now. We have only 1 engineering company, 1 pharma company, no chemicals firm at all but 9 firms in financial services. There is only one non-ferrous company – Vendanta in the index
  • From an ownership viewpoint, there is only one genuine multinational in the Sensex. There are some government owned companies (ONGC, Coal India, Power Grid, NTPC)

What explains these Irrational decisions?

Even accounting for the fact that it is hard to predict future earnings, it is difficult to understand many of the decisions. The answer lies in their selection criteria (provided as an Appendix here). The selection is based purely on size (market capitalization) and liquidity (trading frequency, average daily trades, turnover etc.). Of course, there is a generic term called “acceptable track record”.

What should we be doing?

In the long run, as equity markets evolve, more mature benchmarks with superior selection capabilities will emerge. Until then, diversified multi cap mutual funds run by experienced fund managers with a strong track record and clear investment process will continue to outperform such indices in the long run.

Appendix

BSE Sensex Securities Selection 

The general guidelines for selection of constituent Securities in S&P BSE SENSEX® are as follows.

A. Quantitative Criteria : 

  • Market Capitalization :The Security should figure in the Top 100 companies listed by full market capitalization. The weight of each S&P BSE SENSEX® Security based on free-float should be at least 0.5% of the Index. (Market Capitalization would be averaged for last six months)
  • Trading Frequency : The Security should have been traded on each and every trading day for the last one year. Exception can be made for extreme reasons like Security suspension etc.
  • Average Daily Trades :The Security should be among the Top 150 companies listed by average number of trades per day for the last one year.
  • Average Daily Turnover : The Security should be among the Top 150 companies listed by average value of shares traded per day for the last one year.
  • Industry Representation :The only difference between SCM and TCM is that SCM does not have the rights to clear the trades of other members he can only clear his trades, whereas TCM can clear the trades of any other member
  • Listed History : The Security should have a listing history of at least one year on BSE.
  1. Qualitative Criteria :
  • Track Record :In the opinion of the Committee, the company should have an acceptable track record.

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