The Sensex has delivered a 17 per cent compounded annual return over the last ten years. Good for it.

But it's not one group of 30 stocks that delivered this return. Reason: the index has undergone sweeping changes in the last ten years.

For investors, these changes have big implications. They decide the nature of profits, the extent of volatility in the Sensex and even the index susceptibility to global factors.

A more diversified index

The Bombay Stock Exchange selects stocks in the Sensex based on criteria such as regular trading and the company being in the top 75 based on free-float market capitalisation.

Over the last ten years, the Sensex has been reshuffled 18 times and as many as 26 stocks in the Sensex 30 have been replaced. The changes have resulted in three key trends.

One, as the selection of stocks is now based on a company's free float or non-promoter holdings, stocks with higher liquidity have assumed bigger weights in the index and stocks with lower liquidity have fallen in the rankings.

Castrol India, NIIT, GlaxoSmithKline Pharmaceuticals, Colgate Palmolive and Nestle (India) which were once part of the Sensex are out of it now. Instead we now have HDFC, HDFC Bank, Tata Steel, etc.

Two, the index itself has become more diversified. The top three stocks by weights in Sensex in 2002 were Hindustan Unilever, Reliance Industries and Infosys with a total weight of 45 per cent. Now, the top three — Infosys Technologies, Reliance Industries and ITC — carry a weight of just 29.3 per cent.

No individual stock has a weight of more than 11 per cent in the index. In 2002, Hindustan Unilever, the top stock, had a 20 per cent weight. Today it accounts for 3.5 per cent.

Three, the concentration of the index with a few business groups has reduced. At one point, there were three stocks from the Reliance group — Reliance Industries, Reliance Petroleum and Reliance Infrastructure in the Sensex. In 2006, Reliance Communications too made a debut.

But now Reliance Industries alone remains, with Reliance Infrastructure being replaced by Coal India and Sun Pharma substituting Reliance Communications.

These changes have been influenced by the splitting up of the group, subsequent demergers and loss of market fancy for stocks such as Reliance Communications.

Outgoing stocks generally witness selling pressure in the run-up to the shift, following selling by the index funds that held them. Stocks moving out of the Sensex can also influence other Sensex constituents.

If the incoming stocks carry a high weight (based on free-float market capitalisation), existing stocks in the index too witness some selling pressure, as they ‘adjust' to make room for the new entrant.

For instance, Jaiprakash Associates is set to be replaced by GAIL India with effect from January 9. The free float market-cap of Jaiprakash Associates is Rs 7,893 crore whereas that of Gail is Rs 21,583 crore. This means the existing stocks in the index will also have to lose some weight to ‘accommodate' GAIL India.

Sector rejigs

The Sensex reshuffle has also led to sizeable changes in the sector composition of the index.

The FMCG sector has lost its dominance over the ten-year period, its weight dropping from 30 per cent in 2002 to 12 per cent now. After September 2003, as stocks began to be weighted on their free-float capital, the influence of Hindustan Unilever dropped, while ICICI Bank gained.

Cement and entertainment are the two sectors that have completely moved out of the Sensex in ten years.

Cement stocks ACC, Ambuja Cements and Grasim Industries had a 3.3 per cent weight in 2002. Now, this sector has no representation at all in the index.

Ambuja Cements was replaced by Sterlite industries in 2008, Grasim Industries hived off its cement business into a separate subsidiary and was replaced by Jindal Steel & Power.

In the same year, ACC was also removed and Bajaj Auto replaced it.

The entertainment sector, which was represented by Zee Entertainment in 2002, is also out of the index now.

Zee Entertainment's restructuring in 2005 saw it replaced by Tata Consultancy Services.

One high-profile debutant to the Sensex is the real-estate sector. DLF and Jaiprakash Associates debuted in Sensex during the market highs of 2007-2008, replacing Dr Reddy's Laboratories and Bajaj Auto.

Industry gains weight

As a result of the above changes, the industry-oriented sectors now wield a greater influence over the Sensex than consumer-oriented sectors.

The weight of consumer sectors has fallen from 45.3 per cent in to 34.9 per cent in ten years, making way for higher exposure from industrial sectors such as power, realty and information technology.

Lower exposure to consumer sectors has meant lower price-earnings multiple for the index and less secular growth in profits.

The increased weight to industrial (banks included) sectors meant increased correlation of the stock index to country's economic condition.

This is probably why macro factors such as the index of industrial production, growth/decline in core sectors and Reserve Bank of India's interest rate action have become key factors driving the Sensex in recent years.