Understanding Index

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Introduction to Index

Index is a statistical indicator that measures changes in the economy in general or in particular areas. In case of financial markets, an index is a portfolio of securities that represent 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.

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.

Significance of Index

A stock index is an indicator of the performance of overall market or a particular secto
It serves as a benchmark for portfolio performance - Managed portfolios, belonging either to individuals or mutual funds; use the stock index as a measure for evaluation of their performance.
It is used as an underlying for financial application of derivatives – Various products in OTC and exchange traded markets are based on indices as underlying asset.

TYPES OF STOCK MARKET INDICES

Market Capitalization Weighted Index

In this method of calculation, each stock is given weight according to its market capitalization. So higher the market capitalization of a constituent, higher is its weight in the index.

Market capitalization is the market value of a company, calculated by multiplying the total number of shares outstanding to its current market price.

For example, ABC company with 5,00,00,000 shares outstanding and a share price of Rs 120 per share will have market capitalization of 5,00,00,000 x 120 = Rs 6,00,00,00,000 i.e. 600 Crores.

Free-float Market Capitalization Index

In various businesses, equity holding is divided differently among various stake holders – promoters, institutions, corporates, individuals etc. Market has started to segregate this on the basis of what is readily available for trading or what is not

The one available for immediate trading is categorized as free float. And, if we compute the index based on weights of each security based on free float market cap, it is called free float market capitalization index.

Indeed, both Sensex and Nifty, over a period of time, have moved to free float basis. SX40, index of MSEI is also a free float market capitalization index

Equal Weighted Index

An equally-weighted index makes no distinction between large and small companies, both of which are given equal weighting. The value of the index is generated by adding the prices of each stock in the index and dividing that by the total number of stocks

Equal weight is a type of proportional measuring method that gives the same importance to each stock in a portfolio, index, or index fund.

So stocks of the smallest companies are given equal statistical significance, or weight, to the largest companies when it comes to evaluating the overall group’s performance.

Attributes of an Index

It should reflect the market behaviour

It should be computed by independent third party and be free from influence of any market participant

It should be professionally maintained

What is Impact Cost

Impact cost represents the cost of executing a transaction in a given stock, for a specific predefined order size, at any given point of time

It is a practical and realistic measure of market liquidity; it is closer to the true cost of execution faced by a trader in comparison to the bid-ask spread.

Lets understand it in detail

Features of Impact Cost

It is separately computed for buy and sell

It may vary for different transaction sizes

It is dynamic and depends on the outstanding orders

where a stock is not sufficiently liquid, a penal impact cost is applied

Index management

Index construction, maintenance and revision process is generally done by specialized agencies. For instance, NSE indices are managed by a separate company called NSE Indices Limited.

Index construction is all about choosing the index stocks and deciding on the index calculation methodology. Maintenance means adjusting the index for corporate actions like bonus issue, rights issue, stock split, consolidation, mergers etc.

Revision of index deals with change in the composition of index as such i.e. replacing some existing stocks by the new ones because of change in the trading paradigm of the stocks / interest of market participants.

Index Construction

A good index is a trade-off between diversification and liquidity. A well-diversified index reflects the behaviour of the overall market/ economy. While diversification helps in reducing risk, beyond a point it may not help in the context.

Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Hence, there is little to gain by diversifying beyond a point

Stocks in the index are chosen based on certain pre-determined qualitative and quantitative parameters, laid down by the Index Construction Managers. Once a stock satisfies the eligibility criterion, it is entitled for inclusion in the index. Generally, final decision of inclusion or removal of a security from the index is taken by a specialized committee known as Index Committee.

Index Maintenance and Index Revision

Maintenance and Revision of the indices is done with the help of various mathematical formulae. In order to keep the index comparable across time, the index needs to take into account corporate actions such as stock splits, share issuance, dividends and restructuring events. While index maintenance issue gets triggered by a corporate action, index revision is an unabated phenomenon to ensure that index captures the most vibrant lot of securities in the market and continues to correctly reflect the market.

Major Indices in India

S&P BSE Sensex

S&P BSE Midcap

S&P BSE 100

S&P BSE 200

S&P BSE 500

Nifty

Nifty Next 50

Nifty 100

Nifty 200

Nifty 500

Application of Indices

Traditionally, indices were used as a measure to understand the overall direction of stock market. However, few applications on index have emerged in the investment field. Few of the applications are explained below

Index Funds

These types of funds invest in a specific index with an objective to generate returns equivalent to the return on index. These funds invest in index stocks in the proportions in which these stocks exist in the index.

For instance, 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.