Why we need a new Nifty (and Sensex)

August 10, 2015

It has taken years of coaxing, cajoling and haranguing to get India’s pension monies to trickle into its stock markets. Recently the elephantine Employees Provident Fund Organisation has promised to put Rs. 5,000 crore out of its annual mop-up of Rs.1 lakh crore into domestic equities. Recent tax breaks are also making the National Pension Scheme, which invests up to half its corpus in equities, a hit with retail savers.

All this suggests that a lot of retirement money belonging to Indian savers, in line with global ‘best practices’, is soon likely to find its way into index funds. As Nifty and Sensex ETFs (exchange traded funds) dominate this space, a flash-flood of pension money might rush into the Sensex and Nifty stocks. But is this really such a good idea?

Equity investments in some form are essential to deliver the much-needed kicker to the under-funded retirement kitties of Indian investors. There have been hardly any ten-year periods in India when equities have not delivered a double-digit return, trouncing bank fixed deposits or gold where most people like to squirrel away their savings.

That said, the question is, are the Nifty and Sensex the best wealth-creation vehicles available to Indian equity investors? Stock market history suggests that the answer is an emphatic ‘No’.

In the last 20 years, the Nifty and Sensex have surged eight-fold to deliver an 11 per cent annualised return. But actively managed equity funds have managed twice this return. And there are several quality stocks in the listed space that have delivered more than three times the index returns.
A recent study on wealth creation by Motilal Oswal drives home the difference quite clearly. It noted that while the Sensex or Nifty typically take about 30 years to grow 100-fold in value in the Indian context, quality stocks outside of these indices, selected for their business prospects, healthy cash flows and good governance managed this feat in a mere 12 years.

This shows that investing outside the index basket can help Indian savers to get to their retirement goals more quickly, or with far lower allocations to equities.

Liquidity, not quality

But aren’t the Sensex and Nifty constituents supposed to be the best and brightest of India Inc? Then why aren’t they the top wealth-creators? Well, when the stock exchanges create these bellwether indices, their objective is to come up with a representative basket of stocks which best capture the market mood.

This is why, if you look into the selection criteria for the Nifty, you will find that the primary filters that the NSE uses are liquidity (how much of the stock can be traded without impacting the price), market cap and free float. Profitability, cash flows, shareholder returns or governance record — parameters that matter for long-term wealth creation — simply do not feature on the list.

Nor would index committees, a la Ben Graham, select stocks that are under-valued or out-of-favour in the markets. In fact, they would love to go with the flow. The free float market cap methodology used in the Indian indices deliberately favours momentum stocks.

It adds to the weights of the most active names in the listed universe, while weeding out the inactive ones. This is why the sectors that are most fancied by the market at any given point in time also end up being the largest weights in the indices.

These factors apart, successful stock pickers in India have also created long-term wealth by avoiding cyclical and commodity sectors, while betting on consumer or industrial companies with secular growth.

But given their “bigger-is-better’ motto, the Nifty and the Sensex feature a sizeable allocation to both cyclical and commodity giants. In FY15, commodity behemoths that churn out oil and gas, metals, steel and coal contributed a whopping 40 per cent of the Sensex revenues. Their contribution in the Nifty was 24 per cent.

Given that commodity companies rely, for their sales and profits, on wild-card factors such as global commodity cycles and Chinese demand, their earnings are volatile and quite impossible to predict. This makes such stocks less-than- ideal candidates for parking one’s retirement money.

Not so desi

The third factor that argues against parking Indian pension money in the present indices is their not-so-desi character. If the macro argument for channelling the long-term savings of domestic households into the equity market is that this will aid the growth of the Indian economy, then it would be best to put this capital into companies that actually do business and create employment in India.

But the bellwether indices today feature a sizeable representation from companies with large overseas operations (Vedanta, Tata Steel, Tata Motors and Hindalco, to name a few). Even if you don’t want to mix up patriotism with personal wealth, the significant global operations expose these companies to the shaky global economy.

Now the asset management industry in India may seize on the above arguments to pitch for pension money to be routed into their actively managed funds.

True, actively managed mutual funds have proved pretty good at beating the Nifty or the Sensex and creating substantial investor wealth over the last 20 years.

But the limited track record of active funds in India, the considerable churn both in fund sponsors and portfolio managers and the high cost of active management argue against such a course. Given the notorious lack of depth in the Indian stock market, putting unprecedented amounts of pension money into the hands of individual managers could also endow them with too much influence over stock prices and create conflicts of interest.

Bespoke indices

In this backdrop, one good solution would be for the stock exchanges to design new bespoke indices that could act as the receptacles for pension money. These indices could use fundamental filters to select stocks, rather than liquidity or free-float parameters. Factors such as five-year profit growth, variability of growth, return on equity, free cash-flow generation and institutional holdings can be the primary filters.

In fact, given that the stock exchanges are the primary custodians of all data on corporate announcements, it should even be possible to stitch in qualitative factors such as good governance into the selection process, based on corporate actions, level of disclosure, composition of the Board and so on.

The indices can be reviewed at yearly intervals to weed out poor performers and usher in new firms. Should such indices become available, it would then be easy for ETFs or index funds to passively mirror them and for retirements monies to be funnelled into them.

These index funds may may even give active funds a run for their money. So, will the Indian stock exchanges consider the case for a new Quality Fifty or a Wealth-ex?

AARATI KRISHNAN
This article was published on June 26, 2015, in BusinessLine (The Hindu)