The National Stock Exchange has about 58 Equity related Indices one can track even though most investors / traders follow a very small sub-section of it. Nifty 50 is one of the more widely tracked Indexes in India with the 51 stocks (don’t ask!) of the Index.
While the Index remains a constant, the stocks that are part of the Index see changes over time. Since 1996, the Nifty 50 has seen addition of 86 stocks and removal of 85 stocks. Since April 2016, Nifty 50 has consisted of 51 stocks – this is due to the addition of Tata Motors Ltd DVR. (Tata Motors itself is part of the index, so there are just 50 companies in the index; the only difference is in the voting rights of the holders of DVR shares versus the Ordinary shareholders)
The frequent churn that one has seen in the Indices has also meant that for a few stocks, it has been a merry-go-round with them seeing inclusion / exclusion multiple times. A case in point would be Dr.Reddy’s Laboratories. DRREDDY (ticker symbol on the NSE) was part of the Original 50 stocks but got dropped in 1997. In 1999, the stock was once again included back in the Index but was dropped for the second time in 2008. It saw inclusion for the third time in 2010 and stays as part of the Index since then.
Inclusion of stocks in any index that is tracked by a large number of funds can easily bump up returns of the stock. For instance, just the rumor of inclusion of REC into the MSCI Index drove the stock up 13% earlier today.
Inclusion of stock in an Index can convey positive information about the longevity and prospects of that firm, because of the certification hypothesis (Dhillon and Johnson (1991); and Jain (1987)).
Stock Exclusion from an Index happens due to one of the two key reasons. One would be a period of underperformance which would have dragged down its market capitalization and provide a space for entry of alternatives.
A secondary reason would be based on corporate action of the company such as merger with another company, demerger or delisting.
In 2015, IDFC was removed from the Nifty 50 Index since it was going to demerge from its banking arm. In its place, Bosch found a place in the Index for the first time. The change also meant a reduction in total weight of financial companies while automotive ancillary company weights (as a whole) went up.
Our question is, once a stock is removed or added to the Index, how the stock behaved over the coming one, three and five years.
For our analysis, we have taken data from 2005 to 2017 during which period we saw 45 stocks being added while 44 were removed.
Out of the 44 exclusions, 3 were for reasons of a forthcoming merger while 2 were due to forthcoming de-mergers.
In India, most mergers and demergers have been positive, so let’s ignore that. What about the rest, how did they perform over the coming year, 3 years and 5 Years?
Stocks That Were Removed: The median return of the 37 stocks that were removed and were measured after 1 year, has been 11.33% .
Over 3 years, we have a total of 30 stocks (which stayed out) which delivered median absolute gains of 9.69%. This is small: 9.69% in three years is about 3% a year.
Going further, 22 stocks which were removed and stayed out of the Index for 5 years, median absolute return comes to 45.32%. Again, unimpressive as it’s less than 9% per year.
But are these returns good or bad? The answer to that question lies in the returns generated by stocks that have replaced the above stocks in the Index. Over the same periods of time, 1, 3 and 5 years, median absolute gains by stocks that were included in the Index have been 107.87%, 105.19% and 89.26% respectively.
Meaning: If a stock was included in the index, they’re quite likely to gain big time. Most of the gains seem to come in the first year (median: 108%). Even in a five year time frame, absolute returns are about 90% (which is about 14% a year).
When a stock is added to the index, there are exchange traded funds that will buy in, so that they can track the index. Other market participants who benchmark themselves with the index (such as mutual funds) will also buy so they don’t miss out if that one stock breaks out.
There’s other reasons too, such as increased liquidity for such stocks, and the fact that they are now in the index because their market cap is moving up.
All market-cap weighted Indexes like the Nifty 50 are closet momentum portfolios. They try to keep up with the trend by adding winners (who have moved up in market cap) and eliminating losers. In other words, they follow the maxim: Let your winners ride and cut your losers short. It seems it’s best to just follow what they do.