Diversification is the practice of allocating investments in a way that reduces exposure to any single asset or risk. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt to limit losses from any single security or sector. Mutual funds are known for their diversification, but which index provides proper diversification is what we will explore in this article.
In the context of Indian equity markets, investors often consider Nifty50, Nifty100, and Nifty500 indices for their portfolios. This article explores which of these indices provides the best diversification and evaluates the efficacy of combining Nifty50 with Nifty100 and Nifty500.
The Nifty 50 is a diversified index comprising 50 stocks spanning 13 different sectors of the economy. This index represents approximately 56% of the free float market capitalization of all stocks listed on the National Stock Exchange (NSE).
While the Nifty500 covers about 93% of the total free-float market cap, it is top-heavy. The top 50 stocks in the Nifty 100 Index hold a weightage of over 50%, emphasizing its large-cap focus.
The Nifty 100 encompasses the top 100 companies by full market capitalization from the Nifty 500. It tracks the combined performance of the Nifty 50 and Nifty Next 50 indices. Representing about 69% of the free float market capitalization of NSE-listed stocks, the Nifty 100 provides a comprehensive overview of market trends.
Nifty50 vs. Nifty100
The Nifty100, being a broader index, includes the Nifty50 and an additional 50 stocks. This results in slightly more diversification. Mutual fund investors who prefer more diversification in their portfolios may prefer Nifty 100 over Nifty 50. However, the performance data indicates that the daily returns of Nifty100 closely mirror those of Nifty50 with minor deviations. For example, on June 2, 2023, Nifty50 returned 0.25%, while Nifty100 returned 0.28%.
Nifty50 vs. Nifty500
Nifty500’s inclusion of mid-cap and small-cap stocks adds another layer of diversification, contributing to different performance patterns. Notably, on June 2, 2023, Nifty500 had a return of 0.32% compared to Nifty50’s 0.25%, showing the influence of broader market segments.
Analysis of Correlations
After analyzing the correlations of the Nifty 500 (0.93) and Nifty 100 (0.98) with Nifty 50 as a common investment we found that the Nifty 500 appears to provide better diversification benefits when combined with the Nifty 50 compared to the Nifty 100, as evidenced by a slightly less correlation. This implies that including Nifty 500 with Nifty 50 in your portfolio can potentially reduce overall risk due to their less correlated returns.
The argument for the Nifty500 being better diversified holds in theory, as it covers more stocks. However, the practical impact of this diversification is limited due to its large-cap bias. The bottom 450 stocks in the Nifty500 contribute only around one-third of the weightage, thus having minimal impact on overall returns.
Conclusion
Thus, for a diversified approach for mutual fund investors, combining Nifty50 and Nifty500 indices might be more effective than combining Nifty50 and Nifty 100. This strategy leverages the stability of large caps while capturing growth opportunities in mid-caps as well as the small-caps, ensuring a more robust and diversified portfolio for mutual fund investors.
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. The information is based on various secondary sources on the internet and is subject to change. Please consult with a financial expert before making investment decisions.
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