If you see the composition of the S&P BSE Sensex in March 2006, out of the 30 constituent stocks, 21 have remained in the index over 10 years while the rest have been replaced. This means 30% of the index has changed. Similarly, Nifty 50 has seen around 30% stocks change over the past 10 years. Why do stocks get replaced in an index, and should it matter to you?
An index is a basket of securities that represents a specific section of the capital market. For example, S&P BSE Sensex and Nifty 50 represent the largest (by market capitalisation) and most liquid stocks in the domestic equity market. Whereas, S&P BSE Mid cap index and Nifty Mid cap index represent a set of medium-sized stocks.
Changes in indices take place to keep the selection relevant to the underlying description and also on account of corporate actions like mergers and acquisitions, and new listings. While individual stocks might change in terms of market cap or liquidity, the profile of an entire index should ideally remain within the originally stated objectives. Many indices are also used as benchmarks for privately managed funds and that’s also why their composition has to remain relevant.
If changes take place too frequently, it’s a cause for concern; at the same time, some changes have to take place.
Regular evaluation
Typically, index compositions are reviewed at pre-defined frequencies. In case of indices on BSE and NSE, this is biannual.
Care has to be taken that the reviews are not too frequent so that short-term variations don’t upset the selection. The reviews shouldn’t be too far apart either as that might mean irrelevant stocks being part of the index.
“Each index has its own objective and is designed to measure the performance of securities that qualify for membership as per the index methodology. The index is reviewed twice a year, in June and December. This helps in identifying any outliers and also avoids frequent additions or deletions to the index due to short-term up or down movements of individual securities in the indices,” said Mahavir Kaswa, senior manager–product management, Asia Index Pvt. Ltd, S&P BSE Indices.
However, in some cases, more frequent reviews may be needed. “While review frequency is six months for most indices, for specialised indices, like Nifty High Beta 50 Index and Nifty Low Volatility 50 Index, it is quarterly,” said Mukesh Agarwal, chief executive officer, IISL, a wholly owned subsidiary of NSE that is responsible for construction and maintenance of indices.
Indices have their own rules for stock selection and no two have the same rules.
Here is what you are dealing with when it comes to changes (replacements). For Nifty 50 there were 37 changes and 81 for Nifty 100 in the past 10 years. For Sensex, there were 20 changes and 88 for S&P BSE 100 in the same period. Among global indices, Dow Jones Industrial average Index, a 30-stock index, has seen 16 changes since 2006.
Changes also happen when a company gets acquired by another or is demerged from a parent. You need to watch out for these if you own such a stock. In fact, mergers and acquisitions have been cited as the main reason behind changes in the US-based S&P 500 index.
