Come December 18, the S&P BSE Sensex will feature two more bank stocks — IndusInd Bank and YES Bank, while pharma majors Cipla and Lupin will leave the index to make way for the two private sector lenders.

This would leave just two companies — Sun Pharmaceutical and Dr Reddy’s Laboratories — in the Sensex pack from the pharma sector, the darling of market participants till about a year ago, and which gave investors astronomical returns.

Earlier, Kotak Mahindra Bank was added to the Sensex in June this year. Following the reconstitution, banks will dominate the index basket, as the number of bank stocks will increase to seven out of the 31 stocks. In percentage terms, 22 per cent of S&P BSE Sensex constituents would be from the banking sector. HDFC Bank, SBI, ICICI Bank, Kotak Mahindra Bank and Axis Bank are currently in the Sensex pack.

The market cap-based filters used to add or replace stocks in the index makes sure that sectors that carry high market fancy and momentum constantly replace sectors that are on the losing side. This is what has transpired with pharma, with regulatory risks turning investors off the sector.

The Sensex, first compiled in 1986, is calculated on a market capitalisation-weighted methodology of 30 component stocks with its base year as 1978-79. In the initial years, the manufacturing sector dominated the Sensex with no presence of banking stocks, since there were no listed players. Shares of State Bank of India and HDFC Bank were listed only in 1995, and ICICI Bank still later, in 1997.

From September 1, 2003, the BSE changed its filtering criteria to free-float market capitalisation (market cap of a company excluding promoters’ holding). Therefore, sectors and stocks that witness high trading activity and have significant public holding, make it to the index.

Impact of changes So, when a stock goes out and a new stock comes in, doesn’t that make the index levels non-comparable?

According to the exchanges, one of the important aspects of maintaining continuity with the past is to update the base-year average. The base-year value adjustment ensures that replacement of stocks in the index, additional issue of capital and other corporate announcements such as rights issue, etc, do not distort the historical value of the index for comparability.

Expect more churn In a report in 2015, Ambit Capital had noted that the constitution of the Sensex was extremely dynamic, and ‘churn’ in the Sensex is, in fact, the only constant. Furthermore, ‘churn ratios’ in India are higher than that of other developed as well as emerging markets.

“Our analysis of Sensex churns over 10-year windows from 1986 to date (i.e. 1986-1996, 1987-1997 and so on, to 2004-2014) shows that the churn ratio of the Sensex tends to rise when the economy is undergoing irreversible structural changes,” said the report.

Modi’s ‘resets’ will transform India’s economy, sending the Sensex churn higher from its recent lows, the report added.

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