Your Questions Answered: I want to invest in Sensex tracking mutual funds. Please elaborate its pros and cons

Q. I am a marketing executive working with a MNC in Noida. I have been investing in fixed deposits, gold and government bonds for the past 5 years. Many of my acquaintances have suggested that I should invest in equity through mutual funds. I intend to initially invest in Sensex tracking mutual funds. Can you please throw light on the pros and cons of investing in index mutual funds tracking the Sensex, its composition, and constituents?

Mrityuanjay Agnihotri, Noida, Uttar Pradesh

The S&P BSE Sensex, commonly referred to as the Sensex, is the benchmark index of the Bombay Stock Exchange (BSE). It serves as a barometer of the Indian economy. It consists of 30 of the largest and most actively traded stocks on the BSE. It is important as it provides a gauge of the overall market sentiment and economic trends. The Sensex is a float-adjusted, market capitalization-weighted index, reviewed semi-annually each year in the months of June and December.

History and Evolution

The Sensex was introduced on January 1, 1986, making it the oldest index in India. The Sensex has undergone many methodological changes since its inception to represent the composition of the Indian stock market. The term “Sensex” itself is a portmanteau of “sensitive” and “index,” coined by stock market analyst Deepak Mohoni in 1989.

Composition and Methodology

The Sensex’s constituents are selected based on a number of parameters, including listing on the BSE, large-to-mega-cap size, liquidity, revenue generation from core activities, and sector balance. The Sensex uses a free-float capitalisation method, which considers a company’s float rather than its outstanding shares, excluding restricted stocks not readily available for trading, such as those held by promoters and under lock-in.

The top constituents of Sensex include Reliance Industries, HDFC Bank, ICICI Bank, Infosys, and Larsen & Toubro. To calculate the value of the Sensex, the base year is 1978-79, and the base market capitalisation used was Rs. 2501.24 crore with a base value of 100, according to the BSE.

Selection criteria for the S&P BSE Sensex

Let’s deep dive into the selection parameters required to be part of the Sensex.

Listing on the BSE: In order to be considered for inclusion in the Sensex, a company must be listed on the BSE. The index is further derived from the constituents of the BSE 100.

Market Capitalisation: Companies are shortlisted on the basis of their market capitalisation. The size of a company is a crucial factor in determining its eligibility. Market capitalisation is a clear indicator of a company’s size and stability, which is why it plays a significant role in the selection process.

Liquidity: The third parameter is that the stocks included in the Sensex should be liquid stocks, i.e., should be traded frequently and in large volumes. This ensures that the index remains a true reflection of the market’s movements and can be easily referenced for investment decisions.

Derivative Linkage: The companies forming part of the Sensex should be traded in as derivatives too.

Listing History: In order to be eligible, the company must have a history of being listed on the BSE for a minimum of six months.

The selection criteria for the Sensex are designed to ensure that the Sensex remains a reliable and robust measure of India’s top 30 listed companies. By adhering to these criteria, the Sensex continues to serve as a critical tool for investors, analysts, and policymakers.

Sensex top constituents and their weightage

Heavyweight constituents play an important role in the index movements and are often the focus of investors and market analysts. Let’s deep dive into the composition of these top Sensex constituents by weight and understand their significance in the market.

What is weightage?

The weightage of a company in the Sensex is essentially its value in percentage determined by the free-float market capitalization. A higher weightage of a company means that any price movement in that company will have a more significant impact on the index.

Top constituents of Sensex

Reliance Industries Limited: With a weightage of over 12%, RIL is the biggest constituent of Sensex. RIL is in diverse industries from petrochemicals to telecommunications making it a critical component of the index.

Tata Consultancy Services: One of the largest IT sector companies in India., TCS has a weightage of approximately 9.7%. Its global footprint and innovative solutions contribute to its substantial influence on the Sensex movements.

HDFC Bank: As a leading private sector bank, HDFC commands a significant presence with a weightage of around 7%. Its weightage has been reduced over the years.

Bharti Airtel: Airtel is one of the largest telecom players in the country. Airtel currently has a weightage of 5.4%

ICICI Bank: ICICI Bank, the second largest Indian private bank with a weightage nearing 5.27%, reflects the robustness of the financial sector in the Sensex.

Sectoral composition of the Sensex

The Sensex constituents are leaders in their respective sectors typically. At times there are multiple constituents from one sector. As of mid-2024, the banking sector holds the most substantial weight in the Sensex cumulatively, followed closely by IT and Oil & Gas sectors.

The dynamic nature of Sensex

It’s important to remember that the Sensex constituents are not set in stone—Sensex composition changes along with the market. The weights of the index’s constituents are checked on a bi-annual basis to ensure that it depicts the performance of its constituents accurately. This periodic review allows for the inclusion of companies showing significant growth and the exclusion of companies that no longer meet the criteria, keeping the index dynamic and current.

Investing in funds tracking the Sensex

Sensex has risen by 19.39% in the past 1 year. In the past 5 years, it has risen by 109.4%. Investors can invest in index mutual funds tracking the Sensex in order to invest in the companies constituting the Sensex. Here are the top five index mutual funds (direct schemes) tracking the Sensex based on their AUM:

Source: AMFI website; all data calculated as of 6 July 2024.

Note:Past performance is not an indication of future returns.

Investing in an index fund that tracks the Sensex, the benchmark index of BSE in India can be a strategic move for many investors. These funds aim to replicate the performance of the Sensex by investing in the same stocks and similar proportions as the weightage of the constituents in Sensex. Below is a detailed brief on the advantages and disadvantages of investing in index funds tracking Sensex.

Advantages of investing in a Sensex-tracking index fund

Diversification: Index funds tracking Sensex provide diversification across the 30 large and actively traded companies that constitute the Sensex. This diversification across various sectors and companies helps in diluting volatility from an individual stock.

Cost-effectiveness: Index funds typically have a lower expense ratio than active funds. Because of lower expense ratios compared to actively managed funds, index funds are a cost-effective way to invest in the stock market. They also eliminate the need for extensive research and active management, leading to lower fees.

Simplicity: Index funds are relatively straightforward to understand. Investors can gain exposure to the companies without the complexity associated with research and picking individual stocks.

Performance: Historically, the Sensex has shown remarkable growth, we have mentioned the past one-year performance and five-year performance above. The performance of Sensex reflects the robustness of the Indian economy. Index funds tracking the Sensex allow investors to take part in the growth journey of the Indian economy.

Disadvantages of investing in a Sensex-tracking index fund

Market-cap bias: The Sensex is weighted by market capitalisation. This means larger companies will have a greater impact on the Sensex’s performance. This can skew the index fund’s holdings towards a few dominant stocks that have high weightage. This can potentially reduce the diversification benefits.

Investing in a Sensex-tracking index fund can be a wise choice for those looking for a passive investment strategy that offers diversification, cost-effectiveness, and simplicity. However, it’s important to be aware of the limitations, such as market capitalisation bias. As with any investment, it’s crucial to align the choice of an index fund with one’s financial goals, risk tolerance, and investment horizon.

How are these funds taxed?

The budget 2024 has introduced a revised tax capital gains structure for equity investments, including investment in equity mutual funds. The long-term capital gains (LTCG) tax rate for equity mutual funds has been increased from 10% to 12.5%, effective from July 23, 2024.

Additionally, the short-term capital gains (STCG) tax on equity mutual funds has been raised from 15% to 20%. These changes to the capital gains regime are expected to impact investor sentiment negatively in the short term but they may encourage more sustained, long-term investment in equity mutual funds.

Until 23 July 2024, long-term capital gains up to ₹1 lakh in a financial year were exempt from LTCG. Now, this limit has been extended to ₹1.25 lakh.

Taxation categories post-budget

Under the new capital gains tax regime, mutual fund investments are now classified into two main categories:

Equity Mutual Funds: For funds with more than 65% equity holdings, the STCG tax is 20%, and the LTCG tax is 12.5%, with the long-term defined as holdings for more than one year.

Debt Mutual Funds: These funds are taxed at the marginal rate without any distinction between short-term and long-term investments, remaining unchanged from the previous year.

The Budget 2024 has undoubtedly altered the landscape for equity mutual fund taxation, impacting all equity mutual funds including those funds that track Sensex. There is a clear shift towards long-term investments. While the increased tax rates may initially impact the market sentiment negatively, the overall simplification of the tax structure and the benefits for long-term investors are significant as discussed above.

Conclusion

The Sensex is not only an index that depicts the market performance but is also a symbol of India’s economic progress. It represents the dynamic nature of the Indian stock market and continues to be an essential tool for investors looking to understand and navigate the complexities of financial investments in India.

Understanding the Sensex is crucial for anyone interested in the Indian stock market, whether they are seasoned investors or newcomers. It offers a window into the economic pulse of the nation and remains a key indicator of financial health and prosperity.

Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.

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