Is Nifty 50 Index a proper representation of the Equity Market?

What is an Index?
An Index is an indicator of a stock exchange. Currently, there are 1644 companies listed on NSE as on 30th June 2020. But if you have to answer how is the market performing, would you look at all these stocks one by one? Obviously, No. As boring as it may sound it is not feasible to check these many companies every time. Therefore, an index like Nifty 50 is built to give you an indication of the performance of the top companies listed on NSE.

What is Nifty 50?

Nifty 50 popularly known as NIFTY, is a market index setup by National Stock Exchange. It showcases the top 50 equity stocks traded on the stock exchange based on pre-defined criteria. Ideally, one look at Nifty should indicate how the overall markets are performing.

Is Nifty a correct representation of Markets?
Investors are putting in a lot of thought lately if Nifty is an appropriate representation of the market. Let us understand, why this thought is coming up by looking at the sector representation in the Nifty 50 Index. The sector allocation strengthens the doubts raised on the Nifty 50 Index. The Index is heavily overweight in the Financial Services sector which covers nearly 33% of the index. Top four sectors i.e. Financial Services, IT, Oil & Gas and Consumer Goods make up ~79% of the Index.

What are the constituents of Nifty 50?

We have seen that the portfolio is overweight in top 4 sectors. Let us see what is inside two of these sectors, whether these sectors are well diversified or not –

In the chart above, we see that inside the Financial Services sector the HDFC group has a 16.1% allocation out of the total 33.3% allocated to this sector. Does this story repeat in Oil and Gas Sector? Let us see –

Again, the same story repeats here, or it gets even worse. Of the 16.7% allocated to the Oil and Gas sector, Reliance holds 14.9%. This is a pretty one-sided allocation. There is no need to mention that even a small change in the share prices of Reliance Industries or HDFC Bank shall have a major impact on the Nifty 50 Index. Below are the Top 10 Constituents of Nifty 50 (As on 30th Sep 2020) –

For a portfolio having 50 constituents, 24.6% allocation to the top 2 constituents is huge. This further strengthens the thought if Nifty 50 is a real market indicator? But so far it is still a very popular index used and followed in India.