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Ways to Maximise Gains

There are many possible ways to tweak index-based investing for fetching returns superior than the index

Passive index-based investing is one of the mantras of the mutual fund industry. A broad index gives stable “averaged” returns, which captures the overall market mood without excessive volatility.

There are many possible ways to tweak index based investing. In what follows, we'll look at some, taking the main Indian index, the Nifty, as an example. The Nifty is a free-floated weighted set of 50 stocks comprising the largest listed companies. Stocks with high non-promoter holdings have more influence than stocks with high promoter holding. For example, Infosys has a much higher index-weight than TCS, although TCS has higher market capitalisation. The free-float method underweights PSUs in particular because all PSUs have very high government holdings.

One of the basics of index-investing is that the investor doesn't try to beat the market by discretionary decisions. This saves time, trouble and brokerage. However, there can be tweaks based on index investing -- what one could call “active” index-investing. These methods can fetch a return that is close to the index and maybe, sometimes superior.

For example, an investor may choose to buy the index according to a different set of weights, or equal weights. This gives the same broad coverage but different results. For example, some investors have tried weighting their index-holdings by company turnover, or full-float, rather than free float. In these cases, the investor can rebalance by holding an index fund and adding individual stocks in specific weights. Or he can buy the individual 50 stocks in the desired weights.

Another method is to buy individual index stocks while excluding a certain sector, or to be overweight or underweight in a specific sector. If there is an outperforming or underperforming sector that is pulling up or dragging down returns, and the investor identifies this, he will get excess returns. Sometimes a trader may buy an index fund and then short the stock futures of a specific sector or perhaps, short a sector index like the Bank Nifty.

Other well-known index-based active methods involve being overweight in high-dividend yield stocks. This is based on the logic that a) a high dividend yield improves returns and b) a stock that is high dividend is possibly under-valued and liable to outperform. A variation is to buy the worst performers on the basis that cyclical turnarounds makes future outperformance likely.

Active index investing has advantages and disadvantages. The investor will pay a lot more brokerage. However, he may also receive an excess return from dividends. This will be in his favour since dividend yields are generally much higher than brokerages and active index investing is long-term, not entailing frequent trading.

Second, while active index investing entails some research and discretion, the universe is deliberately restricted. So it doesn't take the same kind of time and trouble to research as chasing small-caps or mid-caps. Nor does it entail the same risks or offer the same potential rewards. Small-caps can become multi-baggers or go into absolute collapse. An index stock is usually not that volatile.

So, let's see what some of these strategies could have returned. The free-float Nifty has swung between a low of 4,888 (October 2012) and a high of 6,229 (May 2013). Currently, at 5,600 level, the index has an annual gain of 5 per cent. It has lost 4 per cent in the last month. Since fixed deposits offered over 7.5 per cent in the same year, this is clearly an underperformance.

Individual Nifty stocks have much greater variance than the index, with a bearish bias. As many as 30 Nifty stocks have seen capital loss. HDFC Bank has a nominal gain of 0.2 per cent. Seventeen stocks have returned over 5 per cent; 15 have returned over 10 per cent; and nine have returned over 20 per cent. Incidentally there isn't a single PSU with positive returns. The only infrastructure company with positive returns is energy-major, Reliance.

An equally weighted portfolio of the same stocks has a more bearish performance with greater volatility due to the adverse advance-decline ratio. It is also more volatile over the same one-year period. An equally weighted portfolio (assuming a normalised value of 1,000 on August 10, 2012) would have lost over 5 per cent nominally. The high-low differential is also more than the free-float Nifty. Let's take a look at the best performers. If we set a cut off at 20 per cent, nine stocks qualify.

This list includes the three IT majors, HCL Tech, TCS and Infosys. There are two pharma majors in Lupin and Dr Reddy's. Then the two FMCG giants, HUL and ITC were also major winners. Airtel and Maruti were other large gainers.

On the flipside, really poor returns have come from 15 stocks that have lost over 20 per cent. This includes six infrastructure-related plays in

JP Associates, Bhel, L&T, DLF, Reliance Infra and Tata Power. It also includes six metals and mining stocks in Jindal S&P, Tata Steel, NMDC, Sesa Goa, Hindalco and Coal India. The other big losers are the PSU banks, PNB, SBI and Bank of Baroda. Ranbaxy is an outlier in that as most other pharma stocks have positive performances.

Similarly, we can also calculate the most volatile stocks by noting the difference between the 52-week low and the 52-week high and expressing that range as a percent of the low. In the last year, the most volatile stocks have all been big losers. This does indicate how much the market has swung in terms of trend.

What about the recent gainers and losers?

Just 11 stocks had positive returns in the past month. The IT majors, HUL, Airtel and Cipla have all continued to do well. Beaten down stocks like Hero, Ranbaxy, Cairn, Jindal and NMDC have seen some sort of revival. The IT stocks will gain so long as the US economic revival continues and the rupee stays weak. HUL has defensive strength. Airtel is a good play if the telecom mess sorts out. The other five are very high-risk but may be high-return. Hero would gain if the two-wheeler industry bottoms out. Cairn may gain on energy policy change. Ranbaxy is still in crisis. Jindal and NMDC will rise with other metal stocks, if global metal prices improve.

Looking at the biggest recent losers, it is evident that pressure on the banking sector is starting to hit, even the private banks. Sun Pharma has taken a big hit settling a patent suit in the US. The rest of the big recent losers are from infra-related sectors. (See table: Biggest losers)

Past performance is no guarantee of future returns as the old disclaimer goes. However, there are several trends of long standing that could help an active index investor to tweak.

* The rupee is likely to weaken further before this crisis plays out. That will help IT and other export oriented companies. Hence, being overweight on IT and maybe, in pharma, may be worthwhile

* PSUs have consistently underperformed since disinvestment started in 1991. Avoidance of PSUs -- being underweight in any government-controlled business should help to boost long-term returns

* Banking is likely to see more stress over the next fiscal. Being underweight in banking and especially in PSU banks could be beneficial

* Metals may have bottomed out or be in the process of bottoming if last-month performance is an indicator. If so, quite a few companies could benefit. This is a function of the global commodity cycle and slower growth in China could disastrously impact it

* Infrastructure related plays are in a mess. A contrarian who went overweight in infrastructure may well make huge capital gains over a two-three year period. Against that, the sector could go through further pains in the short-term

Getting overweight on IT looks a low-risk strategy which would boost returns if the rupee lost more ground. Getting overweight into metals and infra could be high risk /high return punts. If you're systematically invested in a Nifty index-fund/ETF, there is a case for buying puts on the Bank Nifty to hedge potential losses from the financial sector. A much more high-risk trading strategy would be to hold an index fund and short the stock futures of individual PSUs. But if you're buying the index components individually, avoid the PSUs and avoid the banking sector as well.

Devangshu Dutta is an independent financial analyst.

This column first appeared in the October 2013 issue of Wealth Insight.