Relationship Between Fundamental Factors and Stock Returns Amid Index Rebalancing: An Empirical Assessment of the Indian Equity Market

Abstract

This article empirically examines the correlation between firm fundamentals and stock return potential during index rebalancing. The required variables panel format data are derived from Prowess IQ for sample companies within the Nifty 50 index, spanning the period from 2009 to 2023, and transformed into trailing-twelve-month format. In addition to employing company-specific fundamentals as predictors, the study has incorporated market premium and lagged stock returns as independent variables to enhance the model’s prediction accuracy. The high-dimensional fixed effects (HDFE) methodology was employed to assess the relationship between variations in specific variables and stock returns by dividing the data set into pre- and post-inclusion and exclusion intervals, utilising two models of the independent variables—one incorporating current realisations and the other incorporating lagged realisations. The study results reveal intriguing findings that the market risk premium and contrarian effects consistently influence stock earnings during pre- and post-exclusion scenarios. Various factors, including sales, return on equity, returns on capital employed and operating profit margins, demonstrate their significance in fluctuations of stock earnings; however, determining their impact in terms of positive or negative direction during index reorganisation is challenging. A commendable finding of the study is that the constants (error terms) for the exclusion cases produced negative coefficients, while the constants for the inclusion cases delivered positive coefficients. This suggests that additional variables beyond firm-specific fundamentals positively influence stock returns during inclusion and negatively affect them during exclusion. They may pertain to investors’ herd behaviour, positive or negative corporate announcements, mergers or demergers, analysts’ recommendations, or fundamental factors not accounted for in the models. The investment community may utilise the study findings to build suitable investment strategies.