index

What’s an Index?
An Index is a number used to represent the changes in a set of values between a base time period and another time period।

What’s a Stock Index?
A Stock Index is a number that helps you measure the levels of the market. Most stock indexes attempt to be proxies for the market they exist in.
Returns on the index thus are supposed to represent returns on the market i।e. the returns that you could get if you had the entire market in your portfolio.

Why do we need an Index?
Students of Modern Portfolio Theory will appreciate that the aim of every portfolio manager is to beat the market.
In order to benchmark the portfolio against the market we need some efficient proxy for the market.
Indexes arose out of this need for a proxy।

What does the number mean?
The index value is arrived at by calculating the weighted average of the prices of a basket of stocks of a particular portfolio.
This portfolio is called the index portfolio and attempts a high degree of correlation with the market.
Indexes differ based on the method of assigning the weightages to the stocks in the portfolio।

But why a portfolio? Why not the entire market?
This is because for someone who wishes to replicate the return on the market it is infinitely more expensive to buy the whole market and for small portfolio sizes it is almost impossible.
The alternative is to choose a portfolio that has a high degree of correlation with the market.

How are the stocks in the portfolio weighted?
There are basically three types of weighing :
Market Capitalisation weighted
Price weighted
Equal weighted
As may be discerned, the stocks in the index could be weighted based on their individual prices, their market capitalisation or equally।

What is the better weighing option?
The market capitalisation weighted model is the most popular and widely considered to be the best way of determining the index values.
In India both the BSE-30 Sensex and the S&P CNX Nifty are market capitalisation weighted indexes।

Who owns the index? Who computes it ?
Typically exchanges around the world compute their own index and own it too. The Sensex and the Nifty are case in point.
There are notable exceptions like the S&P 500 Index in the U।S. (owned by S&P which is a credit rating company) and the Strait Times Index in Singapore (owned by the newspaper of the same name).

Who decides what stocks to include? How?
Most index providers have a index committee of some sort that decides on the composition of the index based on standardised selection and elimination criteria.
The criteria for selection of course depends on the philosophy of the index and its objective.
Selection Criteria
Most indexes attempt to strike a balance between the following criteria.
Better Industry representation
Maximum coverage of market capitalisation
Higher Liquidity or Lower Impact cost.
Industry Representation
Since the objective of any index is to be a proxy for the market it becomes imperative that the broad industry sectors are faithfully represented in the Index too.
Though this seems like an easy enough task, in practice it is very difficult to achieve due to a number of issues, not least of them being the basic method of industry classification.
Market Capitalisation
Another objective that most index providers strive to achieve is to ensure coverage of some minimum level of the capitalisation of the entire market.
As a result within every industry the largest market capitalisation stocks tend to select themselves.
However it is quite a balancing act to achieve the same minimum level for every industry.
Liquidity or Impact Cost
It is important from the point of usability for all the stocks that are part of the index to be highly liquid. The reasons are two-fold.
An illiquid stock has stale prices and this tends to give a flawed value to the index.
Further for passive fund managers, the entry and exit cost at a particular index level is high if the stocks are illiquid। This cost is also called the impact cost of the index।

What is a Benchmark Index?
An index which acts as the benchmark in the market has an important role to play.
While it has to be responsive to the changes in the market place and allow for new industries or give up on dead industries, at the same time it should also maintain a degree of continuity in order to survive as an benchmark index.
What are the popular indexes in India?
BSE-30 Sensex
BSE-100 Natex
BSE Dollex
BSE-200
BSE-500
S&P CNX Nifty
S&P CNX Nifty Jr.
S&P CNX Defty
S&P CNX Midcap
S&P CNX 500

What are Sectoral Indexes?
These indexes provide the benchmark for sector specific funds.
Fund managers and other investors who track particular sectors of the economy like Technology, Pharmaceuticals, Financial Sector, Manufacturing or Infrastructure use these indexes to keep track of the sector performance।

What are the uses of an Index ?
Index based funds
These funds tend to replicate the index as it is in order to match the returns on the market.This is also know as passive management. Their argument is that it is not possible to beat the market over a sustained period of time through active management and hence it’s better to replicate the index. Example in India are
UTI’s fund on the Sensex
IDBI MF’s fund on the Nifty
Exchange traded funds (ETFs)
These are similar to index funds that are traded on an exchange.
These are pretty popular world wide with non-resident investors who like to take an exposure to the entire market.
S&P’s SPDRs and MSCI’s WEBS products are amongst the most popular products.
Index futures
Index futures are possibly the single most popular exchange traded derivatives products today.
The S&P 500 futures products is the largest traded index futures product in the world.
In India both the BSE and NSE are due to launch their own index futures product on their benchmark indexes the Sensex and the Nifty।

What is the trend abroad?
Although we have a whole host of popular exchange owned indexes abroad including the DAX 30, the CAC 40 and the Hang Seng we see an increasing trend where global index providers are seen to have more influence among the foreign funds and investing community।

What do Global Index providers bring ?
In the age of cross border capital flows and global funds, global index provider provide the uniformity and standardization in their index philosophy and methodologies that allows a global fund to compare performance across regions or sectors.
By following a common industry classification standard in all the countries that they operate in, index providers hope to wean away liquidity from the more popular and home grown indexes.
Also global providers are currently, the only ones in a position to provide pan-continental or pan-global indexes।

What does the future look like?
The future in India looks pretty exciting with Index futures being launched and Index options expected to follow. Hopefully with the growing popularity of ETF’s we might see SEBI allowing them in India too.
Globally while the debate between active and passive fund management still rages, we see standardised indexes growing in popularity.