Nifty 50 vs. Portfolio of Banking + Pharma + IT stocks: Which is better?

If you are not fond of actively managed funds, an investment in a Nifty 50 index fund provides you exposure to a diversified equity portfolio. However, Nifty 50 consists of stocks from different sectors (banking, pharma, energy, commodities, IT, consumer goods, automobiles etc).

Here is the sectoral breakup of Nifty 50 (as on December 31,2020).

Can we better the performance of Nifty 50 using a set of sectoral indices? The outperformance, if any, can be in the form of higher returns or lower volatility.

What do you think?

Let us test this out, using a mix of sectoral indices (Banking, Pharma, and IT).

The Indices and Strategies

We use the data for the last 2 decades for the following indices/strategies.

1. Nifty 50 TRI
2. Nifty Bank TRI
3. Nifty Pharma TRI
4. Nifty IT TRI
5. Banks + Pharma + IT: An equal weighted strategy (1/3^rd) with equal allocation to Nifty Bank, Nifty Pharma and Nifty IT. The portfolio rebalanced to target weights on Jan 1 each year.

Performance Comparison

We compare the performance of the indices/strategy over the past 20 years (January 1, 2001-January 8, 2021).

Nifty 50: Rs 100 grows to Rs 1,514. CAGR of 14.53% p.a.

Nifty Bank TRI: Rs 100 grows to Rs 4,347. CAGR of 20.7% p.a.

Nifty Pharma TRI: Rs 100 grows to Rs 1,593. CAGR of 14.82% p.a.

Nifty IT TRI: Rs 100 grows to Rs 1,169. CAGR of 13.06% p.a.

Banks + Pharma + IT: Rs 100 grows to Rs 2,626. CAGR of 17.72% pa.

The banking stocks have done the best. And the equal weighted strategy (Banks + Pharma + IT) gets the second position, returning more than 3% higher than the Nifty 50. Not bad.

A few caveats here.

1. This is a snapshot in time. We have chosen a start point and an end point. The returns experience may be different for a different set of start and end points. To overcome this, we shall look at rolling returns later in the post.
2. Focusing on returns alone may not be the best approach. If a strategy is very volatile, then it becomes difficult to stick with the strategy during bad times. Need to look at the volatility too. We shall consider maximum drawdowns and rolling risk (volatility) later in the post.
3. The choice of starting point may put the performance of IT index at a disadvantage. We know the time coincides the dotcom crash. As you can see, the outperformance of the Bank Nifty came in the first decade (2001-2010). In the second decade (2011-2020), the IT index has been the best performer among the 3 indices.

Now, to the calendar year returns.

Just look at the variation in the performance of the 3 indices in any of the years. Look at the performance in 2020. Banking index lost you money while the returns from the Pharma and IT index exceeded 50%.

The equal weighted strategy (Banks + Pharma + IT) beats Nifty 50 in 12 out 20 years.

Rolling Returns (Performance Consistency)

We look at 3-year and 5-year rolling returns.

You can see how often the best performing sector (between Banking, Pharma, and IT) becomes the worst performing sector. Hence, sticking to sectoral investing requires skill, discipline, and a monk’s patience. By the way, this was evident from calendar years returns.

The best way to sidestep the highs and lows of individual sectors is to invest in a diversified portfolio (such as Nifty 50) and use a mix of sectoral indices (as our equal weighted strategy does).

Volatility and Drawdowns

We have looked at the returns. Now, let us look at the volatility and drawdowns too.

Maximum drawdown refers to the maximum loss (erosion in value) that you would have experienced after investing on a particular date. Lower drawdowns are preferred because nobody likes big losses. It is difficult to make the most of an investment strategy where you lose big (even if it wins big later) because you might bail out at the wrong time. There is a reason why investor returns are lower than investment returns. Investment discipline is one of them. Big losses can compromise that discipline.

You can notice that IT shows the biggest drawdowns in the initial years. Then, the baton passes to banks. And finally, to Pharma.

The diversified Nifty 50 and the equal weighted portfolio (Banks + Pharma + IT) fare much better. The interesting part is that the equal weighted portfolio (despite being much less diversified than Nifty 50) does almost as well.

The rolling risk chart shows a similar picture. The diversified portfolios are much less volatile (compared to sectoral indices).

By the way, the notice the volatility of the banking index. At the very top. Remember, the banking index gave the best returns over the past 20 years.

Coming to comparatively low volatility of the equal-weighted portfolio (Banks + Pharma + IT), this can be attributed to reasonably low correlations of the sectoral indices. The correlation of monthly returns between the pair of any indices is less than 0.5.

To contrast, the correlation of gold with equity returns is negative. Hence, a mix of gold and equity results in a better diversified portfolio.  We saw this in an earlier post. Low positive correlation is not as good as negative correlation in terms of diversification. Still better than sticking with a single sector.

An additional point to note is that the correlation of Banks + Pharma +IT portfolio with Nifty 50 is 0.91. Expected too. As we mix more and more sectors, the correlation with Nifty 50 will increase. Because that’s what Nifty is. A mix of stocks from multiple sectors.

The Caveats

1. Past performance may not repeat.
2. It is convenient for me to look at the past data, select winning sectors and start drawing conclusions.
3. Why only Banking, Pharma, and IT? Why not FMCG or Oil and Gas or Metals? It is possible that we could have picked up a different mix of 3 indices and ended up with better or worse. I have not tried to test any other combination.
4. Not all best performers will come from these 3 indices. For instance, Reliance Industries, despite being such an investment success over the last 20 years wouldn’t have been part of either of Banking, Pharma, and IT indices.
5. Switching between various sectoral indices (Banking, Pharma, and IT) for rebalancing will entail tax and transaction costs (Brokerage, stamp duty, STT etc). Hence, the results of Banking + Pharma + IT portfolio are overstated.
6. I have picked up total returns index (TRI) for analysis. In real world, even index funds may not be able to replicate the TRI performance accurately. There will be some tracking error.
7. While we have had index funds for Nifty 50 index for a long term, we do not really have index funds for the sectoral funds even now.
8. There is a single index fund for Nifty Bank (from Motilal Oswal AMC). Even that fund was launched only in September 2019. By the way, Nippon Bank BeES (earlier Benchmark AMC and Reliance AMC) was launched in 2004. However, you need to see how comfortable you are trading in ETFs.
9. There are no index funds for Nifty IT index. A couple of ETFs have been launched only in the year 2020.
10. There are no index funds or ETFs for the pharma index.
11. Therefore, even if you knew (had gift of foresight) that this approach will work well, there was no simple way to execute the strategy.
12. By the way, there is no dearth of active funds in banking, pharma, and IT sectors. However, actively managed funds have their own set of problems. The expense ratios will be higher. There will be periods of underperformance (or outperformance) that will test your patience. Our MF industry is dominated by active fund houses. Hence, do not expect sectoral index fund launches in the near future either. Even if (and when) these index funds are launched, it is possible that the expense ratios and tracking error may be higher than a Nifty index fund.
13. Nifty Bank was launched in September 2003. Nifty Pharma was launched in July 2005. The NiftyIndices website does not provide launch date information about Nifty IT index. Thus, some portion of our analysis is on the back tested data.
14. Note that you cannot just mix any 3 indices. In my opinion, the reason why bank, Pharma and IT indices seem to work so well is that their fortunes are driven by different forces. Banking is about performance of local economy while Pharma and IT depend more on global economy and foreign regulations. Or so I think.

What should you do?

Banks + Pharma +IT gives better returns than Nifty 50 at similar or lower volatility.

What should you do?

Invest in Nifty 50 or use the mix of these 3 indices? (Assuming the investment universe is limited to these two choices).

The answer is not so easy.

As discussed earlier, there is no simple way to invest in such a strategy (Banks + Pharma + IT). You will need put in some effort. Even if there were, there is no guarantee that these sectors will be at the forefront of Indian indices in the next 2 decades too. Winners/leaders in the coming decades may come from different sectors.

That is why investing in Nifty 50 seems like a simple and more practical choice.

You can use the equal-weighted strategy or plain sectoral indices in your satellite equity portfolio.

What would you do?

Additional Links

Over the past few months, we have tested various investment strategies or ideas and compared the performance against the Buy-and-Hold Nifty 50 portfolio. In some of the previous posts, we have:

1. Assessed whether adding an International Equity Fund and Gold to an Equity portfolio has improved returns and reduced volatility.
2. Does Momentum Investing work in India?
3. Does Low Volatility investing beat Nifty and Sensex?
4. Performance Comparison: Investing on 52-week Lows vs Investing on 52-week Highs
5. Nifty 200 Momentum 30 Index: Performance Review
6. Nifty Factor Indices (Value, Momentum, Quality, Low Volatility, Alpha): Performance Comparison
7. Nifty Alpha Low Volatility 30: Performance Review
8. 50% Gold + 50% Equity: How does the portfolio perform?
9. What is the Best Asset Allocation for your portfolio? 50:50, 60:40 or 70:30?
10. Considered the data for the past 20 years to see if the Price-Earnings (PE) multiple tells us anything about the prospective returns. It does, or at least has in the past.
11. Tested a momentum strategy to shift between Nifty 50 and a liquid fund and compared the performance against a simple 50:50 annual rebalanced portfolio of Nifty index fund and liquid fund.
12. Used a Simple Moving Average Based Market Entry and Exit Strategy and compared the performance against Buy-and-Hold Nifty 50 over the last two decades.
13. Compared the performance of Nifty Next 50 against Nifty 50 over the last two decades.
14. Compared the performance of Nifty 50 Equal Weight vs Nifty 50 vs Nifty 50 over the last 20 years.
15. Nothing works all the time. Used Nifty 50, Nifty MidCap 150, and Nifty Small Cap 250 index to demonstrate that sometimes intuitive investment choices do not work.
16. Compared the performance of 2 popular balanced funds against a simple combination of an index fund and a liquid fund.
17. Compared the performance of a popular dynamic asset allocation fund (Balanced advantage fund) against an equity index fund and see if it has been able to provide reasonable returns at low volatility.
18. Which is the best date for SIP in mutual funds?

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