Understanding Index and its Application

Index is a statistical indicator that measures changes in the economy. In Financial markets, an index means a portfolio of securities representing a particular market or a portion of a market. Each Index has its own calculation methodology and usually is expressed in terms of a change from a base value. The base value might be as recent as the previous day or many years in the past. Thus, the percentage change is more important than the actual numeric value. Financial indices are created to measure price movement of stocks, bonds, T-bills and other type of financial securities. More specifically, a stock index is created to provide market participants with the information regarding average share price movement in the market. Broad indices are expected to capture the overall behaviour of equity market and need to represent the return obtained by typical portfolios in the country. A stock index is an indicator of the performance of overall market or a particular sector.

There are two main market indices in India. The S&P BSE Sensex representing the Bombay stock exchange and CNX Nifty representing the National Stock exchange.

S&P stands for Standard and Poor’s, a global credit rating agency. S&P has the technical expertise in constructing the index which they have licensed to the BSE. Hence the index also carries the S&P tag.

CNX Nifty consists of the largest and most frequently traded stocks within the National Stock Exchange. It is maintained by India Index Services & Products Limited (IISL), a joint venture of the National Stock Exchange and CRISIL. In fact, the term ‘CNX’ stands for CRISIL and NSE.

An ideal index gives us minute by minute reading about how the market participants perceive the future. The movements in the Index reflects the changing expectations of the market participants. Index rises because the market participants think the future will be better. The index falls when the market participants perceive the future pessimistically.

It serves as a benchmark for portfolio performance belonging to individuals or mutual funds. We can use the stock index as a measure for evaluation of performance.

Index also proves useful as an underlying for financial application of derivatives A number of products in OTC and exchange traded markets are based on indices as underlying asset.

Major Indices in India

These are a few popular indices in India:

• S&P BSE Sensex

• Nifty 50

• S&P BSE Midcap

• S&P BSE 100

• S&P BSE 200

• S&P BSE 500

• Nifty Next 50

• Nifty 100

• Nifty 200

• Nifty 500

Application of Indices

Basically, Indices were used as a benchmark to understand the overall direction of stock market. A few applications on index have evolved in the investment field. Let’s discuss some of the applications are explained below.

Index Funds

Index funds invest in a specific index with an aim to generate returns equal to the return on index. These funds invest in index stocks in the proportions in which these stocks exist in the index. For example, Sensex index fund would get similar returns as that of Sensex index (except for a small “tracking error” which occurs due to fund management related expenses). Since Sensex has 30 shares, the fund will also invest in these 30 companies in the proportion in which they exist in the Sensex. Similarly, a Nifty index fund would invest in the 50 component companies of Nifty index in the same proportion in which they exist in the Nifty index and therefore generates similar returns as that of Nifty index (adjusted for a small “tracking error”).

Index Derivatives

Index Derivatives are derivative contracts which have the index as the underlying asset. Index Options and Index Futures are the most popular derivative contracts worldwide. Index derivatives are useful as a tool to hedge against the market risk.

Exchange Traded Funds

Exchange Traded Funds (ETFs) is basket of securities that trade like individual stock, on an exchange. They have number of advantages over other mutual funds as they can be bought and sold on the exchange. Since, ETFs are traded on exchanges intraday transaction is possible. Further, ETFs can be used as basket trading in terms of the smaller denomination and low transaction cost. The first ETF in Indian Securities Market was the Nifty BeES, introduced by the Benchmark Mutual Fund in December 2001. Prudential ICICI Mutual Fund introduced SPIcE in January 2003, which was the first ETF on Sensex.

Practical uses of the Index

• Information – The index reflects the general market trend for a period of time. The index is a broad representation of the country’s state of the economy. A stock market index that up indicates people are optimistic about the future. Likewise, when the stock market index is down, people are pessimistic about the future.

• Benchmarking – For all the trading or investing activity that one does, a yardstick to measure the performance is required. Assume over the last 1 year you invested Rs.100,000/- and generated Rs.20,000 return to make your total corpus Rs.120,000/-. How do you think you performed? Well on the face of it, a 20% return looks great. However, what if Nifty moved to 7,800 points from 6,000 points generating a return on 30% during the same year? Well, suddenly it may seem to you that you have underperformed the market! If not for the Index, you can’t really figure out how you performed in the stock market. You need the index to benchmark the performance of a trader or investor. Usually, the objective of market participants is to outperform the Index.

• Trading – Trading on the index is probably one of the most popular uses of the index. Majority of the traders in the market trade the index. They take a broader call on the economy or general state of affairs and translate that into a trade. For example, if at any hour, the government of India is expected to announce the budget and at that point Nifty index is at 5000 points. You have an assumption of the budget being favourable to the nation’s economy. After all, the index is the representation of the broader economy. Naturally, the index will move up. So, to trade your point of view, you may want to buy the index at 5000. So as per your prediction, the index moves upwards to 5400. You can now book your profits, and exit the trade at a 400 points profit!

• Portfolio Hedging – Investors usually build a portfolio of securities. A typical portfolio contains 10 – 12 stocks which they would have bought from a long-term perspective. While the stocks are held from a long-term perspective, they could foresee a prolonged adverse movement in the market, potentially eroding the capital in the portfolio. In such a situation, investors can use the index to hedge the portfolio. We will explore this topic in the risk management module.

Index construction methodology

It is important to know how the index is constructed /calculated especially if one wants to advance as an index trader. As we discussed, the Index is a composition of many stocks from different sectors that collectively represent the economy’s state. To include a stock in the index, it should qualify certain criteria. Once qualified as an index stock, it should continue to qualify on the stated criteria. If it fails to maintain the criteria, the stock gets replaced by another stock that qualifies the prerequisites.

Based on the selection procedure, the list of stocks is populated. Each stock in the index should be assigned a certain weightage. Weightage in simpler terms defines how much importance a certain stock in the index gets compared to the others. For example, if ITC Limited has 7.6% weightage on the Nifty 50 index, then it is as good as saying that the 7.6% of Nifty’s movement can be attributed to ITC.

How can we assign weights to the stock that make up the Index?

There are many ways to assign weights, but the Indian stock exchange follows a free-float market capitalization method. The weights are assigned based on the company’s free-float market capitalization, the larger the market capitalization, the higher is the weight.

Free float market capitalization is the product of the total number of shares outstanding in the market and the stock price.

For example, company, ABC has 100 shares outstanding in the market, and the stock price is at 50 then the free-float market cap of ABC is 100*50 = Rs.5,000.

Sector-specific indices

While the Sensex and Nifty represent the broader markets, certain indices represent specific sectors. These are called the sectoral indices. For example, the Bank Nifty on NSE represents the mood specific to the banking industry. The CNX IT on NSE represents the behaviour of all the IT stocks in the stock markets. Both BSE and NSE have sector-specific indexes. The construction and maintenance of these indices are similar to the other major indices.

“An index aids to measure of the state of a market. Index funds are a low-cost way to invest, provide better returns than most fund managers, and help investors to manage their funds and achieve their goals more efficiently.”