The shift towards passive investing is one of the defining trends of this decade. According to NSE Indices’ Nifty Passive Insight report, released in March, assets under management (AUM) in passive schemes stood at ₹14.84 trillion as of end of February, up ninefold from ₹1.63 trillion in 2020.

The passive universe now spans 677 schemes and 54 million folios, with 67% of AUM in equity, and more than half of that benchmarked to the Nifty 50.

The foundation traces back to Nobel laureate William Sharpe, who argued in his 1991 paper The Arithmetic of Active Management that, after costs, the average actively managed dollar must underperform its passive counterpart. The Nifty 50 offers exposure to India’s largest companies at expense ratios of 0.10–0.20%, a fraction of the 1.00–1.75% typically charged by active large-cap funds. Low-cost diversification sits at the core of index investing.

How 50 Stocks Shape the Performance of an Index Fund

A useful starting point is the broader market. The NSE’s April Market Pulse report measures India’s overall market concentration using the Herfindahl-Hirschman Index (HHI). That figure has fallen from 202 in 1995 to 81 in 2025, reflecting a steady dispersion of market capitalisation across a wider set of companies. The markets as a whole are becoming less concentrated over time. The question for an index investor is whether that dispersion shows up in their fund.

The HHI for the Nifty 50, calculated as the sum of the squares of constituent weights, averages 457 across annual factsheets from March 2017 to March 2026. The corresponding figure for the Nifty Next 50 is 244.

By conventional thresholds, where an HHI above 1,500 signals concentration, neither index appears concentrated at the stock level. A more intuitive lens is the effective number of stocks—how many equal-weight names the index behaves like. On that measure, the Nifty 50 averages 22, while the Nifty Next 50 comes in at 41. Two indices, identical stock counts, very different weight distributions.

Key Regulatory Footnotes Every Index Fund Investor Should Know

Securities and Exchange Board of India regulations include a clear safeguard: no diversified equity fund may invest more than 10% of its net asset value (NAV) in a single stock. Passive funds are exempt because they replicate an index. When HDFC Bank’s free-float market cap reaches 13% of the Nifty 50, every fund tracking the index holds it at that weight, with no discretion.

The framework is deliberate and appropriate, but it means the concentration limits governing active funds do not apply to passive ones by design.

Emerging Concerns Around Index Funds and Market Concentration
Academic work on passive investing has begun to examine a related dynamic. As more capital flows into market-cap-weighted indices, the largest stocks attract proportionally greater passive inflows, further expanding their market capitalisation and index weight. Some researchers argue this can amplify skew over time, dampen price discovery and raise correlations among index constituents. The long-term systemic effects of passive investing at scale remain an open question.

Index Fund Analysis: What the Data Actually Reveals

None of this is an argument against the Nifty 50 or passive investing. The cost advantage, behavioural discipline and long-term performance record are well established. The Nifty 50 is simply a useful case study in one respect: diversification is not just a function of stock count.

The HHI data offers a clearer view of what investors own. When roughly 40% of an index sits in five stocks and more than half in ten, it is worth knowing. The concentration is not limited to individual names; it extends to sectors as well. The Market Pulse report (April 2026) notes that financials now account for 25% of India’s total listed market capitalisation, up from 10% in 1995. Within the Nifty 50, financial services make up about 35% of index weight as of March 2026.

Analysis of NSE index factsheets from 2017 to 2026 shows sector-level HHI has averaged above 1,100 over the past decade, with financial services, IT and refineries together accounting for 52–66% of the index each year.

For investors building passive portfolios, the practical questions are straightforward: how are weights distributed, how has that distribution evolved, and does it align with the intended outcome? The answers shape not just which index to track, but how to combine exposures across segments to achieve the diversification that passive investing, at its best, can deliver.

Author: Dr. Rachana Baid, Professor & Dean- Academics, NISM

This article was originally published in The Mint : https://www.livemint.com/money/index-funds-fewer-stocks-matter-more-than-you-think-passive-investing-11777045409568.html