Index Basics - I

Introduction

Some like to ride sleek bikes while some others like to go high on alcohol till the wee hours of the morning, yet some prefer to climb heights to feel on top of the world. But there exists a curious breed of people, young and old, managers and housewives, pensioners and students, who are on a perpetually high five days a week between 10 a.m. and 3.30 p.m. Their world of happiness gyrates around the daily movement of the 'Sensex'. An odd four-figure number is what they want to see going up (or is it the opposite way for some?) and in this process they sometimes tend to forget the maxim that what goes up has to come down. All this is good till the time it lasts. But when the story reverses its script, these are the very same people who display several withdrawal symptoms - sometimes going to the extreme. Yet there are several others who inhabit this planet for whom the stock market is a piece of 'existential dilemma'. For them, the stock index is not a barometer of the state of the economy but of the nation's collective paranoia. Their question is why do people have to follow it? The answer from the other side may well be - Because it is there? So while it is there, why not try and demystify its existence and learn something more about it?

What are the objectives/purpose of an index?

A stock market index reflects the overall behavior/returns/movements of the equity markets as a whole. The returns on the market index should ideally represent the returns obtained on any standard portfolios. The second use of an index could be in the form of a benchmark for measuring fund performance. An index with a good track record makes an ideal benchmark for fund managers to compare the performance of their funds and portfolio. The third use of an index is that it can be used to trade derivatives and for launching index based products and funds.

What is the basic philosophy on which the index is constructed?

Price movements in equity are on account of any one or both of two reasons viz., news related to the company and news related to the country or the economy. The idea of an index is to capture and reflect the effect of the latter part on the market and this is achieved by averaging. Typically the company specific news would be averaged out as the good news of one company is countered by bad news of another. Thus, the movement in the index would reflect only the effect of the news on the country and economy only.

Diversification is the key to achieving averaging wherein the individual stock fluctuations are cancelled out in the movement of the index. In its movement, a well-diversified index will reflect only the news common to the market as a whole.

If diversification is good and is achieved by adding more number of scrips to the index, then why not construct an index consisting of all the scrips in the market?

It is a fact that more number of scrips does indeed contribute to reduced risk as well as better diversification. Beyond a point, say 50 scrips, there is not much to be gained in terms of diversification and a lot to be invested in terms of logistics and administrative effort. The more important issue is considering the quality of the scrip rather than the number of scrips.

What are the desirable features of an index?

As said earlier, an ideal index should consist of such stocks so that it can easily capture and reflect any affect a certain development in the company or something related to the Indian industry or economy. For this, the stock should be such that it is traded regularly on the bourse. If this were the case, then the stock price would react immediately to any change that has taken place. But a company whose stock is not traded regularly causes an inexplicable and sometimes disproportionate change in the index, when it is suddenly traded. This change reflects the old information regarding the company and reduces the accuracy of the index. Thus, such an index is not a good indicator of the market status.

Stocks, which are not traded regularly on the exchanges, are generally refereed to as illiquid stocks. For example, stocks like Wipro and Motor Industries Company (MICO) are thinly traded and only partly reflect the current market sentiments. Thus, we come to the first important attribute of a good index - liquidity. Liquidity is also about being able to buy and sell shares at a price close to the current market price. In other words, the narrower the bid-ask price, the more liquid the stock. For example, the bid-ask spread of RIL is typically 10 to 20 paise. In other words, if the market price is Rs315, then it is possible to buy the RIL stock at around Rs315.15. In this case, when the bid-ask price band is low, then the so-called 'impact' cost is minimum.

Now we come to a new concept called 'impact' cost. Let us try to explain this in some detail. Consider the following data.

Order book of X security -

Impact cost for buying 1,500 shares -
Ideal price is defined as the average of the best bid and best ask prices. Therefore, ideal price = 98.00+99.00/2=98.50
Actual buy price = {(1000*99)+(500*100)}/1500=99.33
Impact cost for buying 1500 shares = 99.33-98.50/98.50 * 100 = 0.84%

Market impact cost is the best measure of the liquidity of a stock. For eg, a stock to qualify for possible inclusion into the CNX Nifty, the market impact cost should be below 1.5% when doing S&P CNX Nifty trades of Rs50mn. (CNX Nifty trade would mean that one buys all 50 stocks in proportion to their market capitalization). An S&P Nifty trade would mean that one buys all 50 stocks, in correct proportions of their market cap.

The other desirable attributes of an index are:-

a) Value-weighted index
Generally, an index can be either price or value weighted. In the former, a weight assigned to a stock is proportional to its price. In the latter, each stock in the index affects the index value in proportion to the market value of all shares outstanding. In this system, for eg, IBM and Microsoft would have roughly equal weights as their market values are similar. But in the price-weighted system, a small capitalization firm could have a higher weight than a larger firm if the small capitalization firm had a high stock price but relatively few outstanding shares. An example of a price-weighted index is the Nikkei while NYSE and S & P 500 are value-weighted indexes.

b) Familiarity
The index chosen should preferably be widely known and accepted. It must be capable of being computed rapidly. A long-time series of the index should be available which would illustrate the risk/return characteristics under a variety of historical conditions.

c) Representation
The index chosen should include shares, which represent a reasonably large number of shares of companies with high market capitalization. In other words, it should try and capture the behavior of large and well-diversified portfolios in the country. This is necessary to avoid price manipulation. Moreover, the future evolution of the index should be governed by a clearly defined set of rules. Human discretion in the selection of scrips would make it biased. Any change in the scrips should not be sudden - for that would disrupt the character of the index.

d) Easy arbitrage
Shares included should be highly liquid so as to facilitate easy arbitrage. If this is not the case, the "no-arbitrage band" around the fair price of the futures would become wide and hedgers would be paying a larger penalty for their use of hedging services.

e) Hedging effectiveness
For a portfolio manager, the main use of an index future is for hedging. A good index is one which gives high hedging effectiveness i.e. the index should correlate well with ones portfolio - whatever it may be. A good index should give a very high-risk reduction when a portfolio owner short sells the index futures. The index must adequately reflect "market risk". High hedging effectiveness should be from the viewpoint of fund managers, investor's etc. However, the objectives of liquidity and hedging effectiveness are not fully compatible. The best index in terms of hedging effectiveness will essentially consist of all the firms quoted on the exchange. This would make the index less liquid.

f) Regular updates
Any good index should be reviewed on a regular basis and brought into line with the current economic scenario and the performance of various industries in the country. For example, the most recent change in the Sensex incorporated two scrips from the software sector, one from the pharma industry and the other one was involved in petrochemicals and refining. The change acknowledged the current trend of investors to buy software and information technology scrips as the industry has been doing well in the past few years. However, change brought about should be continuos. It is always healthy that the index is changed after a period of, say, two years rather than a long period of inaction followed by a sudden change of a large number of scrips

Click here for the next chapter - Index Basics - Part II