Beat the index with same stocks

Being overweight on non-PSU index stocks and underweight on PSU stocks will help reap richer returns

The uneven nature of equity returns is of course the main reason it is considered risky. But decades of experience tells us that equity gives better long-term returns than other assets. Passive systematic investment in broadly diversified indices or in widely diversified mutual funds (MFs) is an easy way to stay ahead of inflation.

Over the past 10 years (since January 1996) for instance, inflation as measured by the Wholesale Price Index (WPI) has a CAGR (compound annual growth rate) of about 5.5 per cent and the Nifty returns for that period are about 11.5 per cent compounded, (ignoring dividend yield of about 1.5 per cent per annum). This is a massive premium over wholesale inflation.

An active investor might look for a low-risk way to outscore passive index returns. One way is to stay with a portfolio that consists of more or less the same population of stocks but buy these in different weights compared to the index. This is what a lot of diversified MFs do. In theory, such a portfolio can outperform simply through good timing.

Another relatively low-risk method is to increase the amount of buying on corrections. This is a variation on the Martingale betting strategy used by gamblers who increase stakes after a loss. The difference in an investment scenario is that the investor doesn't book losses; he only averages down the cost of acquisition.

This method does seem to add a little to the overall returns. But there could be problems with such a staggered systematic investment method if a bear market lasts for a very long time. The investor will have steadily increasing exposure to a loss-making investment. Very few have the self-confidence or stubbornness to do this indefinitely.

The investor who does this must also decide on a mechanical formula. For example, if the market falls 20 per cent, does he increase his monthly commitment by 20 per cent? This involves reviewing investible resources and working out optimal asset allocations.

The dividend "dogs" formula is another relatively low-risk mechanical method. The investor picks up the five index stocks with the highest dividend yield and the poorest returns in terms of capital gains. The dividend yield provides a cushion and there is always the hope that a turnaround will make a multi-bagger out of one or more of these underperformers.

Another method is to hold an index-based portfolio with a few extra stocks that could offer very high capital gains and, thus, add to overall returns. There is a balancing issue with this method. A small stake in one or two potential multi-bagger will not make a difference to a large portfolio. A large stake in a few potential multi-baggers imbalances the portfolio.

Another interesting try is to create a portfolio of index stocks with different weights. The Nifty and Sensex, for example, are both weighted by free float. This method favours widely-held stocks. An investor could instead, choose to weight the same basket by overall market capitalisation (ignoring free float) or by turnover. In practice, this would mean topping an index exchange-traded fund (ETF) by buying individual stocks in appropriate amounts to change the weights. The pecking order changes when weighting by turnover or by overall market capitalisation. This favours public sector undertakings (PSUs), generally closely held, with the Government of India (GoI) having a very large stake. Many PSUs also have high turnover.

State Bank of India, for example, has thrice the turnover of HDFC Bank, although it has a much higher index weight due to free-float criteria. Similarly, Power Grid, NTPC, Bharat Heavy Electricals would move up the pecking order. But PSUs, as a rule, have underperformed broader indices and the historical returns actually drop if the weighting method changes in this way.

Of course, there are no guarantees PSUs will continue to underperform but there is a good chance this will happen. PSUs underperform simply because the government is bad at running businesses and that looks unlikely to change very much. Disinvestment will free more floating stock in many PSUs and that could lead to some methodological changes. PSU weights might rise in the indices. On the other hand, share prices could fall if there is a larger supply.

So, an index-based portfolio, where PSUs are underweighted, will probably outperform the index itself. An investor could consider creating such an exposure by buying individual, non-PSU index stocks to add to a basic index ETF position. This would be another method of trying to outperform a passive index position without taking high risks.