Is the euphoria over benchmark indices justified?

Most of the stocks that retail investors follow are outside the sudden rise in the Sensex or the Nifty

Most of us get swayed by a rise in the benchmark indices - Sensex or Nifty. With newspapers and television channels going to town about how the Sensex has breached 20,000 or the Nifty has crossed 6,000, it is not a surprise that investors are lulled into believing that this is the beginning of a new dawn for the market. But it is important to remember that while the benchmark indices are steady, most of the large-cap, mid-cap and small-cap stocks have taken a huge beating in the market.

Therefore, it is important to have a right benchmark for performance and the benchmark itself should be well constituted to reflect the correct picture.

A benchmark is a standard against which the performance of an equity stock or equity mutual fund can be measured. Generally, the broad market and market-segment stocks are used for this purpose. When evaluating the performance of any investment, it's important to compare it against an appropriate benchmark.

For example a fund investing in large cap stocks should benchmark or compare its performance with BSE Sensex or CNX S&P Nifty. Similarly, a fund investing in Information technology stocks should benchmark the performance with BSE IT index. Apart from this the constitution of the said index should also have a right representation. This means that there should not be too much of concentration of a few stocks or too much weightage for a few stocks in a few sectors. 

The companies in Sensex represents less than one per cent of the total number of companies listed on the Bombay Stock Exchange (more than 5,000 companies), but they account for around 50 per cent of the BSE's total market capitalisation. The total market capitalisation of BSE is more than Rs 63,000 crore out of which more than Rs 32,000 crore are accounted for by the Sensex companies. In other words, the fortunes of the Sensex 30 or NIFTY 50 hold disproportionate sway over policymakers, media and the public at large.

Although Sensex or Nifty are important indices, they do not represent the general market. Let us see why:

Heavy weightage to large five or six companies: Sensex and Nifty is made of 30 and 50 companies respectively representing different sectors of the economy. However, five or six large companies alone have a weightage of more than 40 to 50 per cent percent allowing a clear distortion of the index.

Trading impact of institutions: The index at times can be ramped up or hammered down by trading in few select stocks. While this may create an impression that the economic factors are improving or deteriorating, the actual situation may be very different.

Change in stock composition in the index: The stocks in the index are continuously updated based on the momentum, liquidity, free float, etc. This does not allow a clear comparison as the new stocks may move in different proportion as compared to the stocks which were earlier part of the index.

Stocks in benchmark indices may be more insulated others: The stocks in the index are very dominant and more or less have a sound business model. This, at times, insulates them from the vagaries of the economic upturns and downturns. The mid-cap and small-cap stocks are affected more during a downturn, than say large-cap stocks. As a result the index cannot be said to be a true representative of the general market.

As the table shows, the Sensex and Nifty have shown a modest increase. However, Information Technology, healthcare and FMCG have shown a significant appreciation in prices in spite of the weak market sentiments. The stocks in realty, capital goods, public sector undertakings, power, consumer durables and banking have shown a decline in prices.

The disconnect between the Nifty and Sensex with the mid-cap and small-cap stocks is also clear from the table. The mid-cap and small-cap have declined significantly whereas the Nifty and Sensex are more less steady.

Investors need to look at not only the benchmark indices, but also the performance of sectoral indices. They also need to take into account the other indicators such as Gross Domestic Product, Monetary policy measures, inflation, Index of Industrial Production, foreign exchange trend, etc, before deciding on any investment.

The author is a freelance writer