Nifty or Sensex: Which is the Better Choice?

Due to their simplicity, low cost and ease of manageability, investing in index funds is considered to be an excellent choice for nearly every investor. However, the confusion stems from making a choice between Nifty and Sensex. The article provides guidelines on how to go about it

The invention of index fund is compared to the likes of the invention of the wheel, the alphabet and the Gutenberg printing press by Paul Samuelson, a Nobel Laureate. He further said that mutual fund never made its inventor, John Bogle, rich but elevated the long-term returns of the mutual fund owners. Index investing is an investment strategy that takes very little investment knowledge, no skill and practically no time or effort. And the best part is that it outperforms most of the actively managed funds in the longer period. One of the reasons mutual funds outperform is because of their low cost.

At the end of July 2021, the median expense ratio of large-capdedicated actively managed funds was 1.1 per cent as compared to 0.23 per cent of index funds. It shows that actively managed funds charge almost five times higher than the passively managed index funds. Due to their comparatively higher costs most active fund managers have to outperform their respective index by an average of 0.9 per cent per year just to match the performance of an index fund. For the same large-cap funds, the difference in median returns between actively managed funds and passively managed funds is very negligible – to the tune of 13 per cent or 13 basis points.

Due to their simplicity, low cost and ease of manageability, investing in index funds is considered to be an excellent choice for nearly every investor. Nonetheless, it is not as easy as it sounds and you have to take the right decisions as fund houses have launched a slew of new index products in response to the popularity of index investing. For example, if you want to invest in large-cap dedicated stocks, there are index funds based on Nifty Next 50, Nifty 50, Sensex and Nifty 100 indices, all of which are large-cap-dedicated funds. So as an investor you might be confused about which index fund to invest in. We will analyse two of the most popular large-cap-dedicated index funds based on Sensex and Nifty.

Sensex versus Nifty

The Sensex, one of the oldest benchmark indices of the Bombay Stock Exchange (BSE), constitutes 30 stocks. On the other hand, Nifty is the benchmark index of the National Stock Exchange (NSE) and has 50 stocks. Both indices adopt the free-float market capitalisation weighted methodology. The market capitalisation of a company is calculated by taking the equity’s price and multiplying it by the number of shares readily available in the market. The free-float methodology calculates the market capitalisation of the index’s underlying companies.

This excludes locked-in shares such as those held by company executives or promoters or the government. Now, if you have decided to take exposure to large-cap-dedicated index funds you should decide between the two. To understand which is better we have analysed the risk return statistics of both the indices since the start of March 1990. The following table shows the risk return statistics of the indices.

The table above shows that the Sensex has generated better absolute returns since the year 1990. When compared in terms of annualised returns, though it looks very negligible and inconsequential, it is huge when you take the cost of your investment and returns. For every Rs 1,000 invested in the Sensex at the start of March 1990, you would have got Rs 527 more than Nifty 50. This is despite the fact that historically a majority of the stocks that comprise the Nifty and the Sensex tend to overlap. We tried to segregate this period of a little more than 31 years – March 1990 to August 2021 – into different 10-years and 20-year periods to understand if such an outperformance is by chance. We found that except for 2000-2021 of the 21-year period, Sensex has always outperformed the Nifty. One of the reasons for such outperformance is due to a concentrated portfolio of Sensex as compared to Nifty.

A concentrated portfolio has the tendency to generate better returns than a diversified portfolio; however, it also can be more volatile. This is also reflected in the annualised volatility of both the indices. While the Sensex has yearly volatility of 31.68 per cent, Nifty has yearly volatility of 30.71 per cent. Even if we measure risk through maximum drawdown, we find that the Sensex has larger drawdown. In the last 31 years the Sensex has dropped by as much as 60.91 per cent from its peak while Nifty has fallen by 59.86 per cent from its peak. It is clear therefore that the Sensex carries a slightly higher risk as compared to Nifty but also provides higher return than Nifty.

Now the question is whether it makes sense to take the risk of investing in Sensex and whether the outperformance justifies the risk. To evaluate the risk-adjusted return we took two ratios: the first is the Sharpe ratio which measures the return generated for every unit of risk taken and the second is the Sortino ratio which considers only returns less than a benchmark or required rate of return as risky. In case of Sharpe ratio, it penalises upside and downside volatility equally. While the yearly Sharpe ratio remains same for both the indices, Sensex scores over Nifty when it comes to the Sortino ratio. For the Sensex it is 1.55 while for Nifty it is 1.54.

In all the periods of our study, Sensex has always had more Sortino ratio than the Nifty. So, if you are interested in investing in an index fund for a longer horizon to make it a part of your core portfolio, the Sensex looks better. Although it is more concentrated than Nifty, the 30 companies provide enough diversification. Internationally we have seen that the Dow Jones Industrial Index with 30 stocks has performed better than many other stock indices with larger constituents. We believe diversification becomes more important in case of a mid-cap and small cap portfolio. Since Nifty and Sensex are large-capbased indices, wide diversification may not be required.

And generally speaking, only the largest and most profitable companies in India make it to the Sensex. Once you have decided on the indices, the next step is to choose the right index fund. You should ensure that you pitch for a fund with higher assets under management (AUMs). Higher AUM is better in case there is redemption pressure on the fund. Ensure that the fund you choose also has a low expense ratio. Zero down on a fund that has returns similar to that of the index it is tracking. The difference between the fund’s and the index’s returns is called tracking error. The lower, the better!