On the occasion of the 50th anniversary of the prominent benchmark that symbolizes India's economic prowess, the National Stock Exchange of India (NSE) unveiled the "Nifty 50 Stock of the Nation" report. This insightful report sheds light on the intricacies of Nifty, a key player in the vast $3.6 trillion Indian Stock Market. Its timing couldn't be more perfect, as it serves as an educational tool for both individual and institutional investors. The report underscores a critical fact: despite the apparent stability, investing a substantial 65% of resources into just three out of the 18 sectors paints a picture of concentration, not diversification, which inevitably translates to heightened risk.
However, the issue of concentration isn't exclusive to India's 50 stocks; it's rooted in the methodology employed to construct these indices. Originating in 1871, this methodology carries an inherent bias that has been acknowledged by mathematical experts in indexing, albeit without a lasting solution. Consequently, what began as a practical calculation tool has become an integral part of modern investment practices. Fortunately, progress cannot be halted, and the realm of science continues to evolve through the relentless pursuit of answers.
This leads us to a pivotal question: Does Nifty 50 genuinely capture the potential it could have achieved with a more robust methodology? Put simply, what could a more unbiased representation of Nifty 50 have yielded? To explore this, we can analyze the average component ownership of Nifty 50 over the last five decades. Much like the sector skew, the index exhibits a component weight skew, where a mere five out of the 50 stocks contribute nearly 40% of the index's value. This skew, while natural, inevitably influences the index's performance.
The underlying concept of wealth erosion due to index funds is straightforward. Indexes tend to be concentrated and skewed, at times allocating 80% of resources to just 20% of stocks. Concentration implies less diversification and, by extension, more pronounced risk. While embracing greater risk can yield rewards when markets are on an upswing, the same risk can become a liability when markets stagnate or correct. Unfortunately, this fundamental logic has been somewhat overlooked in the realm of index funds since their inception in the 1980s. Today, these funds permeate various financial avenues, including pensions and sovereign funds, thereby posing a potential threat to the stability of capital markets as they tend to follow herd behavior. I've discussed the perils of market capitalization-based investing in previous writings, employing analogies to make the concept accessible even to small investors who might not question the index design.
Let's employ a bit of simple math to illustrate the potential gains that Nifty 50 could have realized with a more appropriate design. A superior index design isn't merely about accurate representation; it holds the power to drive tangible benefits for investors who rely on indexes to deliver results. Indexes fuel index funds, which in turn impact pensions. Therefore, it's logical that a poorly structured, concentrated, and biased approach could end up eroding wealth rather than preserving or generating it. This is why the term "Poor Stock of the Nation" aptly captures the sentiment.
Imagine if Nifty 50 had been conceived as an investable idea 27 years ago, similar to the transformation of the American S&P 500 into an index fund in 1976. How might a superior design have spurred wealth creation? To comprehend this, we can simulate various excess returns—essentially the added returns a better design could have generated—and observe their compounding effects over 27 years. Assuming a modern indexing approach could outperform the average 13.5% annualized return and achieve an additional 10% annually.
For instance, at a 13.5% annualized return, turning a $1000 investment into $5000 would take approximately 30.04 years. Conversely, with a 23.5% annualized return, the same objective could be accomplished in just 17.33 years. This simple illustration underscores how a mere 10 percentage points increase in annualized returns can halve the time required to achieve a financial goal. While it may sound elementary, constructing a superior, more representative index is far from rocket science. It involves creating a model that adheres to open, consistent, testable, and comparable rules, ultimately empowering investors by offering solutions that generate more returns with lesser risk.
In essence, the "Nifty 50: A Glimpse into the Nation's Stock Performance" report not only dissects the current investment landscape but also sparks a discourse on how to enhance it. It challenges us to reconsider conventional approaches, reminding us that progress lies in asking the right questions and pursuing innovative solutions. By embracing this ethos, we can truly shape a more prosperous future for investors, steering them away from the pitfalls of poor index design and towards the promise of wealth generation.
Workings
I have generated the doubling table for the following annualized interest rates: 13.5%, 15.5%, 17.5%, 19.5%, 21.5%, and 23.5%. To do this, I have used two methods: the rule of 72 and the natural logarithm formula. The rule of 72 is a quick and easy way to estimate the doubling time by dividing 72 by the interest rate (as a percentage). The natural logarithm formula is more accurate and uses the following equation:
Doubling Time =ln(2)/ln(1+r)
Where:
lnln is the natural logarithm
r is the interest rate (as a decimal, not a percentage)
Using these methods, I have created the following table:
As you can see, the rule of 72 gives a close estimate, but the natural logarithm formula gives a more precise answer. Higher excess returns with improved methodology can generate wealth faster which is a flip side of reduced risk.
Bibliography
Nifty 50 - Stock of the Nation report