What happens when a heavyweight stock stumbles in Dalal Street? A top wealth advisor explains

Stock market indexes track the performance of a basket of companies. But what happens when a giant stumbles? This can trigger a significant decline in the overall index level. In an interview to BT Money Today, Anurag Jhanwar, partner and co-founder of Upwisery Private Wealth, explains how a sharp decline in the price of a heavyweight stock, a company with a significant influence on the index, can trigger a substantial drop in the overall index level.

Edited Excerpts:

How is the inclusion of stocks determined in an index fund?

In India, we mostly follow market capitalization-weighted indices for broad market indices. In these indices, the components are weighted according to their market capitalization. This method gives more weight to companies with a larger market capitalization (the current market price of a company’s outstanding shares multiplied by the total number of outstanding shares). The Nifty 50 and BSE Sensex are examples of market capitalization-weighted indices. The inclusion of a stock in an index is based on its market cap; as long as the stock maintains the required market capitalization, it remains part of the index.

Index Re-Balancing: The index is re-balanced on a semi-annual basis. The cut-off dates are January 31 and July 31 of each year. For the semi-annual review of indices, average data for six months ending on the cut-off date is considered. Four weeks prior notice is given to the market from the date of change.

Can a sharp correction of a heavyweight in the index impact the entire index? Can you illustrate an example to explain this?

Yes, a sharp correction of a heavyweight stock in an index can significantly impact the entire index. This is because indices like the Nifty 50 are weighted by market capitalization, meaning that stocks with higher market capitalization have a greater influence on the index’s overall performance.

Example: HDFC Bank is one of the largest components of the Nifty 50 by market capitalization.

Let’s illustrate a hypothetical example:

Nifty 50 Level: 21,500
HDFC Market Capitalization in Nifty 50: 11.07%
HDFC Stock Price: Rs 1,700
Now, suppose a sharp correction occurs, and HDFC’s share price drops by 20% in a single day. Therefore, the new stock price would be Rs 1,360. The impact on the index would be as follows:

Nifty 50 contribution from HDFC: 11.07% of 21,500 = 2,380.05 points
HDFC impact: 20% of 2,380.05 = 476.01 points
Hence, the new levels for the Nifty 50 Index are:

Initial Nifty 50: 21,500
Impact of HDFC fall: -476.01 points
New Nifty 50 Levels: 21,023.99
This example illustrates how a sharp correction in a heavyweight stock like HDFC, which has a significant share in the index, can lead to a substantial drop in the overall index level. The larger the weight of the stock in the index, the more pronounced the impact of its price movement on the index.

In an active fund, the fund manager can completely exit from a particular stock showcasing non-performance or a sudden fall. How is this not really possible with an index fund?

In an index fund, the investment strategy is to replicate the performance of a specific index, such as the Nifty 50, by holding the same stocks in the same proportions as the index. An index fund operates more like a train on a pre-defined track. The fund manager of an index fund does not have the discretion to sell a stock based on its performance. The composition of the fund must match the index, so if a stock is in the index, it must be in the fund. Since index funds are fully invested in the market at all times, they are fully exposed to market risks. When the market undergoes a sharp correction, index funds mirror the decline of the entire market, leading to significant losses for investors.

What should an investor do to cushion this impact because of a heavyweight’s sudden fall? Is there an alternative index formation method?

Alternative Index Formation Methods:

Equal-Weighted Indices:
The Equal Weight (EW) Index aims to measure the performance of constituents forming part of the parent index, for example, the Nifty 50 Index, where each company in the index is assigned equal weights irrespective of the market cap of the company/stock.

Benefit: It reduces the impact of any single stock’s poor performance on the overall index performance.

Other advantages:

Diversification: Every company has the same weight, ensuring a more balanced exposure across sectors and company sizes.
Reduced concentration risk: An equal-weight portfolio spreads investment across all holdings, reducing reliance on the performance of a few large companies. This can lead to a smoother ride with less volatility compared to market-cap-weighted indexes.
Exposure to smaller businesses: Investors are exposed to smaller businesses with more room for expansion than bigger businesses.
Realistic market reflection: These funds offer a more realistic reflection of the overall market due to their lack of large-cap company overweighting.

What should be the ideal portfolio exposure of passive funds allocation?

There is no standard rule or defined allocation towards a passive strategy. The exposure to passive funds in a portfolio depends on several factors, including an individual’s investment goals, risk tolerance, time horizon, and personal preferences. Ideally, 10% to 20% of the portfolio can be allocated to a passive strategy. Again, one should consult their financial advisor for the right allocation towards active and passive strategies.