Real Returns . Is the Nifty Next 50 a good investment?

With actively managed mutual funds struggling to beat their indices last year, there’s been a surge in popularity for index funds. Funds mirroring the Nifty 50 and Sensex 30 have been around for a long time. But index funds tracking the Nifty Next 50 are the rage this time around, with fund houses that don’t offer this product rushing to launch them.

But, is this just a passing fad or does it make sense for investors to add a Nifty Next 50 fund to their long-term portfolios? A decision to invest in any passive product should be made on the basis of the composition of the index it tracks and its risk-reward behaviour over the long term.

Defensive tilt

If the bellwether Nifty 50 is made up of the top 50 stocks in the Indian market, filtered by their free float market capitalisation, liquidity and other parameters, the Nifty Next 50 is made up of the next 50 stocks using the very same screeners. It, however, ends up with a very different sector composition from the Nifty 50.

As of end-January 2019, consumer goods (29 per cent), financial services (17.6 per cent), pharma (13 per cent), automobiles (9 per cent) and cement (7 per cent) were the top sector weights in the Next 50. This contrasts with financial services making up an overwhelming weight of 38 per cent in the Nifty 50, followed by energy (15 per cent) and IT (15 per cent). Overall, ‘growth’ stocks with a defensive bias carry a far higher weight in the Next 50 compared with the Nifty 50.

The Next 50’s portfolio composition can be both a plus and a minus. Tilted towards secular growth stocks, the Next 50 has delivered stellar performance in the last 10 years, which was a sluggish period for economic growth. But if boom times return for the economy, the cyclicals-heavy Nifty 50 could catch up. Thanks to its growth stock focus, the Next 50’s portfolio PE was at a steep 40 times by end-January 2019, compared with 26 times for the Nifty 50.

Nifty incubator

Given that it picks up stocks falling just short of the top 50, the Nifty Next 50 is seen as an incubator for emerging bluechips hoping to make it to the big league. That makes a Nifty Next 50 fund a lower-risk way for investors to play the mid-cap opportunity.

An NSE white paper tells us that in the 18 years since the index’s inception, 41 stocks from the Nifty Next 50 have graduated to the Nifty 50 by climbing the size and market capitalisation rankings. In every year in the last decade, 3-6 stocks have moved from the Next 50 to the Nifty 50. On the flip side though, stocks that drop out of the Nifty 50 because they have lost market favour or suffered price erosion can also get added to the Nifty Next 50. Lupin and HPCL are a couple of stocks that entered the Next 50 in recent months after they were dropped from the Nifty 50. This is not a bad proposition if you are a contrarian investor. But it does dilute the Nifty incubator argument for investing in the Next 50.

Healthy 5-year show

Most investment products that turn suddenly popular do so on the basis of their recent performance, and the Nifty Next 50 index is no exception. With an 18.6 per cent CAGR in the past five years, the Next 50 has beaten the Nifty 50 (13.1 per cent) hands down on a total return basis including dividends. It has also outpaced active large-cap funds (category average 12.9 per cent) and multi-cap funds (15.3 per cent). On a 10-year basis, its hefty 22.6 per cent CAGR compares with 16.3 per cent on the Nifty 50 and 15.6 per cent on large-cap funds.

But trailing returns can be heavily influenced by the start and end points of the calculation. Therefore, to gauge the usual return experience of investors, rolling returns over a long period are more useful.

Running a rolling-return analysis on the month-end values of the Next 50 index for the last 18 years (February 2001 to February 2019), the index has delivered a CAGR of 16 per cent on average for investors who held it for five years. That’s better than the Nifty 50’s 12.6 per cent rolling returns.

In its best five-year block, the Next 50, with a 54 per cent CAGR, outdid the Nifty 50’s 44 per cent. In its worst five years, its negative CAGR of 3.3 per cent was better than the Nifty 50’s negative 4.7 per cent.

The rolling returns analysis tells us that, if willing to hold on for five years, there’s a pretty good chance of beating the bellwether with the Nifty Next 50.

Bumpier ride

But to reap the rewards of investing in this index, investors must prepare for a very bumpy ride in the short term. In every big bear year over the last decade, the Nifty Next 50 has suffered drastic draw-downs, far worse than the market.

In the dot-com bubble burst from March 2000 to March 2001, the Next 50 crashed by 57 per cent while the Nifty 50 dropped 25 per cent. Post the global financial crisis of 2008, it registered a 66 per cent fall compared with the Nifty 50’s 52 per cent.

In the mini-bear market in 2011, it lost a third of its value while the Nifty 50 dipped 25 per cent. The Nifty Next 50 has been an ordinary performer in the last one year, too, declining 10 per cent, while the senior Nifty gained 3 per cent. It is the Next 50’s ability to deliver three-digit gains in bull years that makes up for its drastic declines in bear markets.

To sum up, yes, the Nifty Next 50 is a good portfolio addition for investors targeting better-than-Nifty returns at low costs. But to reap the high rewards from investing in it, you need to hang on through the years when it delivers big losses.

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