Risk and reward: Why Nifty Next 50 index funds are a double-edged sword

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The Nifty Next50 index has been in the news lately due to the fall in Adani group stocks, which had a reasonably large allocation in the index.

The Next50 is one of the favorite indices of passive investors after bellwether Nifty50, so investors were wondering whether it made sense to continue investing in the Nifty Next50 or not after the Adani wipeout.

How does Nifty Next50 differ from Nifty50?

While the Nifty50 index is made up of the top 50 stocks by market cap in India, the Nifty Next50 is made up of the next 50 stocks, i.e., those ranked 51-100 by marketcap.

But while the Next50 is also a largecap index as its constituent stocks qualify as largecap stocks (as per the SEBI definition), it is also true that given the nature and volatility of stocks, and comparatively larger impact costs, the Nifty Next50 behaves a lot like a midcap index when it comes to volatility.

But with higher risks comes the higher return potential of the Nifty Next50 compared to the Nifty50. And this return potential is what lured most investors to the Next50. A look at broad historical market data shows that during bullish periods, the Next50 generally tends to do better than the Nifty50. But during market corrections, it also falls more.

The Nifty Next 50 is generally seen as an index from where stocks move to the Nifty. This is not as easy as it sounds as Nifty50 stocks have high marketcap entry barriers. Even so, those that are removed from the Nifty50 (due to poor performance) often end up moving down to the Next50. And when such stocks continue to underperform, it hurts the Nifty Next50’s return.

Also see: MC30 List of top funds

So, should you invest in the Nifty Next50?

The Nifty Next50 is a volatile index that behaves like a non-largecap index and sees periods of underperformance compared to the Nifty50. So, to put it bluntly, it is neither for the faint-hearted, nor for those who are unwilling to accept high volatility. Investors also need to have patience to live through down periods.

If that is fine, then the Nifty Next50 can still be considered for its comparatively higher return potential over the longer term. If not, then such investors are better off taking exposure to passive funds only via Nifty50 index funds. They don’t need to invest in Next50-based funds.

Given the difficulty that active largecap funds face in beating the indices (read why here), this is what an investor can do to include passive index funds in a mutual fund portfolio:

- Pick only Nifty50-based index funds if you don’t want too much volatility and are unwilling to take higher risks.

- Consider investing in Nifty100 based index funds if you want very limited exposure to the high-risk, high-return investment strategy provided by the Next50. The Nifty100 has an allocation of about 85% to the Nifty50 and just 15% to the Nifty Next50. This level of allocation can work for those who want the majority of their allocation in the core Nifty50 index and only a small kicker for potentially higher returns via Next50-based index funds.  Do read why Nifty50 + Next50 is Not the same as Nifty100.

- Sufficiently aggressive investors can have a standalone allocation to the Next50 in addition to the Nifty50. The actual allocation of the Nifty Next50 can be from 20-40%. The remaining 60-80% can be to the Nifty50.

- Ride the Nifty Midcap150. In recent years, index funds based on the Nifty Midcap150 have also come up as viable alternatives to Next50-based funds on a rolling-return profile.

If one is open to both passive and active investment strategies, it is always advisable to have a mix of passive and active funds in the portfolio. Largecap exposure can be via Nifty50-based index funds, while mid- and smallcap exposure can be via active funds.

Also read: MC30 Top Picks: Why ICICI Prudential Nifty Next 50 Index fund is a must-have passive scheme for investors