The Sensex does not seem to represent the Indian economy correctly. The index needs to be made more broad-based in terms of number of companies and sectors. Also emerging companies should be adequately represented in Sensex, so as to reflect the Indian economy fully

How do you gauge the mood of stock market in India? How do you decide whether things are hunky-dory or depressing in the stock market?  How do you take a call to make an entry into the market or exit out of it? Though the answers to all these questions are not very easy, one very obvious parameter which gives a good understanding with respect to these questions is to look at the ‘Sensex’ and its movements. The Sensex has always been termed as the barometer of the economy and no wonder daily analysis of the stock market for business news channels starts with a mention of movement in the Sensex and ends with the same as well. Sensex commands the same position in the stock market which ‘Xerox’ has in the photo copy business and ‘Bisleri’ has for mineral water. This is say that if we treat Sensex as a brand then it has a very strong brand recall. But does ‘Sensex’ indeed reflect the mood of the stock market and is it indeed barometer of the Indian economy? Do we indeed need to follow ‘Sensex’ the way we do it?
 

Let us look at some interesting facts to understand certain limitations which Sensex has as an index. These limitations can be classified as follows:
 

Sensex movement is extremely sensitive to 6 companies:  Sensex is made of 30 companies representing different sectors of the economy. But the fact is that six companies alone can easily alter the movement of the index and give us false impression of market movement in general. Let us look at the data Sensex data in this connection:

It is very obvious that because of the dominant representation of the top six companies in the Sensex, the much-tracked index becomes extremely sensitive to price movement of these companies. Do these six companies mirror Indian economy? Not really.

Surprisingly two out of these six companies are from one corporate house only i.e. HDFC. If 14% of an index is one corporate house of the economy, then it goes on to show how the Sensex can easily get influenced by a decision making activity of this corporate house, though it may not be intentional. It is understood that the Sensex is built on free market capital capitalization method which gives representation to stocks broadly based on their market capitalization but had the Sensex been more broad-based, this shortcoming would have been removed.

Sensex has skewed sectoral representation: Like dominance of certain stocks having the ability to influence the Sensex movement, sectoral representation in the Sensex also looks skewed. Let us look at the data below for sectoral representation of the stocks in the Sensex.

Finance, Oil & Gas and IT have around 50% weightage in the Sensex. Issue is not with only skewed sectoral distribution, but also the fact these sectors are extremely sensitive in terms of price movement and provide undesirable volatility to the index. History shows us that the financial sector has been extremely sensitive to monetary policy, oil and gas to international crude prices and IT to foreign exchange movement. The Sensex volatility exposes investors to portfolio risk in case they try to replicate the Sensex in their portfolio.
 

Sensex does not capture the mood of change in economy correctly:  If you look at the way stocks have been included and excluded from the Sensex since June 2006, you get an idea that inclusions and exclusions are not always based on logic. How can one explain the fact that Sun Pharma, which was included in Sensex on 12 January 2009, was excluded on 3May 2010 and was again included on 8August 2011? Inclusions and exclusions should not be so frequent in any index, especially considering that an index like the Sensex is often projected as an index which measures barometer of the Indian economy.
 

Additionally, several stocks have been making a come back in the Sensex frequently. Out of 15 stocks which have been excluded from the Sensex post June 2006, six have made a comeback in Sensex which is clearly evident from the table below.

If stocks make such frequent come back in the index, won’t it be fair to say that the index is not capturing the mood of the economy correctly. Ideally new stocks which reflect the emerging economy should also be included in the Sensex by making it more broad-based.
 

Usage of Sensex can be manipulated by fund managers:  Many fund managers use the Sensex as the benchmark index for measuring and showing performance of schemes of their funds. These schemes do not replicate stocks in the index, barring cases of index funds which have stocks almost in the same pattern as the index.  It is very easy for fund managers to manipulate the performance of their schemes operating against the Sensex because of limitations such as skewed distribution of the sectors and stocks in the Sensex. It is a different story that many of fund managers still find it difficult to beat the benchmark index.
 

The Sensex does not seem to represent the Indian economy correctly. The movement in the Sensex often misrepresents the behavior of the Indian economy in general and stock market in particular. The index needs to be made more broad-based in terms of number of companies and sectors. Also emerging companies should be adequately represented in Sensex.