A Primer on Stock Indices

A stock index is a statistical measure that exhibits the changes in the trends of the stock market in general. Indices are used to represent the performance of the broader security market, or a particular segment of it. An index is created by clubbing together stocks based on a pre-defined criterion which depends on the characteristics of a specific index. The value of the index is calculated using the values of the underlying stocks that make up the index. Consequently, any changes in the prices of these stocks will impact the overall value of the index. Therefore, let’s say that if a majority of the stocks in the index were to witness an increase in their prices, the value of the index will go up as a whole and vice-versa.

Index Construction and Management

Indices are constructed by using various methods. A good index is a trade-off between diversification and liquidity. The process starts by identifying stocks to include in the index. These are chosen based on certain qualitative and quantitative parameters, laid down by the index construction managers or entity. However, index providing entities must make several critical decisions such as what is the target market the index is intended to measure, which stocks from the target market should be included, how often should the index be rebalanced and when should the selection and weighting of securities be re-examined. 

The target market may be defined very broadly (e.g. stocks in India) or narrowly (e.g. Small-Cap stocks in India). It may also be defined by geographic region or by economic sector (e.g. cyclical stocks). The underlying stocks in the index could be all the stocks in that market or just a representative sample. The selection process may be determined by an objective rule or subjectively. Also, in order to keep the index comparable across time, maintenance is done in which various corporate actions like stock splits, mergers, bonuses and right issues are taken into consideration. The process is known as index maintenance and revision.

One should keep in mind that each underlying stock in an index has a different price and the price change in one particular stock would not be proportionately equal to the other stocks. Ergo, the value of the index cannot be determined as a simple sum of the prices of all the stocks which are part of the index. Here is when the importance of assigning weightage to each underlying stock in an index comes into play. The weight represents the extent of the impact that the stock’s price change has on the value of the index. 

The different weighting schemes used in index construction are as follows:
■ Price-Weighted — It is simply an arithmetic average of the prices of the stocks included in the index.
■ Equal-Weighted — Herein equal weight is assigned to each stock in the index.
■ Market Capitalisation-Weighted — Weights are based on the market capitalisation of each index stock (current stock price multiplied by the number of shares outstanding) as a proportion of the total market capitalisation of all the stocks in the index. It is also known as value-weighted index.
■ Float-Adjusted Market Capitalisation-Weighted — Weights are based on the proportionate value of each company’s shares that are available to investors (i.e. free float) to the total market value of the shares of index stocks that are available to investors.

Index Rebalancing
Index rebalancing refers to adjusting the weights of securities in a portfolio to their target weights after price changes have affected the weights. For index calculations, rebalancing to target weights on the index stocks is done on a periodic basis, which is usually quarterly. Index reconstitution refers to periodically adding and removing stocks that make up an index. Stocks are removed if they no longer meet the index criteria and are replaced by other stocks that do. Indices are reconstituted to reflect corporate events such as bankruptcy, merging or delisting of index firms and are subjective. It should be noted that additions and deletions from indices also require that the weights on the returns of other index stocks be adjusted to conform to the desired weighting scheme. 

Significance of Indices
Frontline stock market indices act as a barometer of a country’s financial infrastructure. They reflect the ups and downs in an economy on a macro level. Indices are useful for assessing the general direction in which the equity market seems to be heading as well as gauging the current trends. An index is a key indicator of investor confidence and sentiment. An index can be used to evaluate the performance of a particular mutual fund or PMS. Since portfolio performance depends to a large degree on its chosen style, the benchmark index should be consistent with the manager’s investment approach and style to assess the manager’s skill accurately. The index stocks should be those that the manager will actually choose from.

For example, performance of a FMCG thematic fund should be compared against an FMCG sectoral index and not a broad market index because portfolio stocks will be selected from among FMCG stocks. Stock indices act as model portfolios for index funds. Investors who wish to invest passively can invest in an index fund, which tracks a particular index to replicate the returns delivered by that specific index. There are index mutual funds and index exchange-traded funds, as well as private portfolios that are structured to match the return of an index. Price action in the underlying stocks of sectoral indices makes it easier to understand which sector is gaining traction and finding favour among investors. It helps in identifying welltimed investment opportunities from the mushrooming sector.

Frontline Indian and Global Indices

Sensex —Sensex is the most popular index under the Bombay Stock Exchange’s umbrella. Established in 1875, BSE is Asia’s oldest stock exchange. A blend of two terms, sensitive and index, Sensex constitutes 30 of the largest and most actively traded stocks on the BSE from 12 different sectors. BSE Sensex was first published on January 1, 1986 and is often regarded as the pulse of the stock markets in India. Sensex is calculated using the free float market capitalisation methodology. This method takes into account the proportion of shares that can be readily traded. Ratio and proportion is used on the base index of 100 to arrive at the value of Sensex. The formula is as follows: Sensex = Total free float market capitalisation | Base market capitalisation x Base index value.

Nifty — Nifty is the index of the National Stock Exchange (NSE), another popular stock exchange in India. It represents the weighted average of 50 of the largest Indian companies listed on the National Stock Exchange. It was introduced in 1996 and is maintained by India Index Services and Products Limited (IISL) which is a joint venture of the National Stock Exchange and CRISIL. It is computed using the free float market capitalisation-weighted method wherein the level of the index reflects the total market value of all the stocks in the index relative to the base period, November 3, 1995. 

The formula for calculation of Nifty is as follows: Nifty = Current market value | Base market capital x Base index value. Note: The base index value, in this case, is 1,000. The following table summarises some of the noteworthy characteristics and year-to-date (YTD) performance of various global indices. Notice from the table that most security market indices are market capitalisation-weighted and often adjusted for the float (securities actually available for purchase). The number of securities in many of these indices can vary.