Faqs about Indices

They reflect the changing expectations of the stock market about future dividends of India's corporate sector. When the index goes up, it is because the stock market thinks that the prospective dividends in the future will be better than previously thought. When prospects of dividends in the future become pessimistic, the index drops. The ideal index gives us instant-to-instant readings about how the stock market perceives the future of India's corporate sector.

Every stock price moves for two possible reasons: news about the company (e.g. a product launch, or the closure of a factory, etc.) or news about the country (e.g. nuclear bombs, or a budget announcement, etc.). The job of an index is to purely capture the second part, the movements of the stock market as a whole (i.e. news about the country). This is achieved by averaging. Each stock contains a mixture of these two elements - stock news and index news. When we take an average of returns on many stocks, the individual stock news tends to cancel out. On any one day, there would be good stock-specific news for a few companies and bad stock-specific news for others. In a good index, these will cancel out, and the only thing left will be news that is common to all stocks. The news that is common to all stocks is news about India. That is what the index will capture.

For technical reasons, it turns out that the correct method of averaging is to take a weighted average, and give each stock a weight proportional to its market capitalisation. Suppose an index contains two stocks A and B. A has a market capitalisation of ₹ 1000 crore and B has a market capitalisation of ₹ 3000 crore. Then we attach a weight of 1/4 to movements in A and 3/4 to movements in B.

It is easy to create a portfolio, which will reliably get the same returns as the index. i.e. if the index goes up by 4%, this portfolio will also go up by 4%. Suppose an index is made of two stocks, one with a market cap of ₹ 1000 crore and another with a market cap of ₹ 3000 crore. Then the index portfolio will assign a weight of 25% to the first and 75% weight to the second. If we form a portfolio of the two stocks, with a weight of 25% on the first and 75% on the second, then the portfolio returns will equal the index returns. So if you want to buy ₹ 1 lakh of this two-stock index, you would buy ₹ 25,000 of the first and ₹ 75,000 of the second; this portfolio would exactly mimic the two-stock index. A stock market index is hence just like other price indices in showing what is happening on the overall indices -- the wholesale price index is a comparable example. In addition, the stock market index is attainable as a portfolio.

Traditionally, indices have been used as information sources. By looking at an index we know how the market is faring. This information aspect also figures in myriad applications of stock market indices in economic research. This is particularly valuable when an index reflects highly up to date information (a central issue which is discussed in detail ahead) and the portfolio of an investor contains illiquid securities - in this case, the index is a lead indicator of how the overall portfolio will fare.

In recent years, indices have come to the fore owing to direct applications in finance, in the form of index funds and index derivatives. Index funds are funds which passively 'invest in the index'. Index derivatives allow people to cheaply alter their risk exposure to an index (this is called hedging) and to implement forecasts about index movements (this is called speculation). Hedging using index derivatives has become a central part of risk management in the modern economy. These applications are now a multi-trillion dollar industry worldwide, and they are critically linked up to market indices.

Finally, indices serve as a benchmark for measuring the performance of fund managers. An all-equity fund should obtain returns like the overall stock market index. A 50:50 debt:equity fund should obtain returns close to those obtained by an investment of 50% in the index and 50% in fixed income. A well-specified relationship between an investor and a fund manager should explicitly define the benchmark against which the fund manager will be compared, and in what fashion.

The most important type of market index is the broad-market index, consisting of the large, liquid stocks of the country. In most countries, a single major index dominates benchmarking, index funds, index derivatives and research applications. In addition, more specialised indices often find interesting applications. In India, we have seen situations where a dedicated industry fund uses an industry index as a benchmark. In India, where clear categories of ownership groups exist, it becomes interesting to examine the performance of classes of companies sorted by ownership group.

It is, indeed, the case that putting more stocks into an index yields more diversification. However, two things go wrong when we do this too much: First, there are diminishing returns to diversification. 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. The more serious problem lies in the stocks that we take into an index when it is broadened. If the stock is illiquid, the observed prices yield contaminated information and actually worsen an index.

Illiquid stocks yield bad price data; so the best quality data will come from the most liquid exchange. In India, that is NSE. The NIFTY 50 uses price data from NSE for calculations.

Suppose we look at the closing price of an index. It is supposed to reflect the state of the stock market at 3:30 PM on NSE. Suppose an illiquid stock is in the index. The last traded price (LTP) of the stock might be an hour, or a day, or a week old! The index is supposed to show how the stock market perceives the future of the corporate sector at 3:30 PM. When an illiquid stock injects these 'stale prices' into the calculation of an index, it makes the index more stale. It reduces the accuracy with which the index reflects information.

Suppose a stock trades at bid 1440 ask 1490. Suppose no news appears for ten minutes. But, over this period, suppose that a buy order first comes in (at ₹ 1490) followed by a sell order (at 1440). This sequence of events makes it seem that the stock price has dropped by ₹ 50. This is a totally spurious price movement! Even when no news is breaking, when a stock price is not changing, the 'bid-ask bounce' is about prices bouncing up and down between bid and ask. These changes are spurious. This problem is the greatest with illiquid stocks where the bid-ask spread is wide. When an index component shows such price changes it contaminates the index.

The index is a large entity and is intrinsically harder to manipulate when compared to individual stocks. Obviously, larger indices are harder to manipulate than smaller indices. The weak links in an index are the large, illiquid stocks. These are the achilles heel where a manipulator obtains maximum impact upon the index at minimum cost. Optimal index manipulation consists of attacking these stocks. This is one more reason why illiquid stocks should be excluded from a market index; indeed this aspect requires that the liquidity of a stock in an index should be proportional to its market capitalisation.

NIFTY 50

Suppose a stock trades at bid 99 and ask 101. We say the "ideal" price is ₹ 100. Now, suppose a buy order for 1000 shares goes through at ₹ 102. Then we say the market impact cost at 1000 shares is 2%. If a buy order for 2000 shares goes through at ₹ 104, we say the market impact cost at 2000 shares is 4%. Market impact cost is the best measure of the liquidity of a stock. It accurately reflects the costs faced when actually trading an index. For a stock to qualify for possible inclusion into the NIFTY 50, it has to reliably have market impact cost of below 0.50 % when doing NIFTY 50 trades of twp crore rupees.

Earlier, we said that the index assigns weightages to index components, and the weight of a stock is proportional to its market capitalisation. This idea can be applied to buying the NIFTY 50. If you buy all 50 stocks in the NIFTY 50, in correct proportions, that would be called "an index trade".

It is safe to think that the impact cost is 0.1% or so. This means that if NIFTY 50 is at 1000, a buy order goes through at 1001 and a sell order gets 999. NSE's NEAT software has special facilities to enable buying or selling the entire the NIFTY 50 at one shot. The impact cost is not something fixed. It changes, depending upon the liquidity of the market. Indeed, the time-series of the NIFTY 50 impact cost is one of the best measures of changes in market liquidity over the years.

No. There are mathematical formulas, which ensure that yesterday's value and today's are comparable, even if a change in composition takes place in-between. Think of an index as a portfolio. The composition of the portfolio changes, but it is still meaningful to keep measuring the overnight returns on the portfolio from day to day. These returns, cumulated up, are the index level.

Of course they will. Hence there are no speculators on the internal committee of NSE Indices, which manages the index revisions. Further, there are objective, publicly defined rules which determine when stocks come in and go out of the index. There isn't much room for personal judgement here.

NSE has the best surveillance procedures in India, so the extent of market manipulation is minimum there. In NSE, the professional staff of the surveillance department has no positions on the market. This elimination of conflicts of interest generates a more honest focus upon eliminating market manipulation. On a day to day basis millions of shares get traded on the NSE generating huge order flows. Due to the liquidity and order flow from numerous market players manipulation of the closing price becomes very hard. NSE is the most liquid exchange in India. Hence, the prices observed there are the most reliable. NSE has the highest trading intensity (reducing stale prices) and their bid-ask spreads are the tightest (reducing bid-ask bounce). This is assisted by the fact that the NSE tick size is ₹ 0.05 for all stocks, which encourages tight bid-ask spreads.

What is commonly reported as NIFTY 50 on TV and in the newspapers is actually the NIFTY 50 Price Index. It only reflects changes in prices. NSE Indices also calculates something called the NIFTY 50 Total Returns (TR) index. This shows the returns on the index portfolio, inclusive of dividends. This is the appropriate benchmark for mutual funds, which do earn dividends. Both NIFTY 50 and NIFTY 50 TR use a base of 3 November 1995 as 1000. On December 31, 2001, i.e. nearly six years later, NIFTY 50 was at 1059.05 while NIFTY 50 TR was at 1150.28. The difference in the two levels is the return obtained on reinvestment of dividends through the intervening period.

No. The market-cap weighted index is "self weighting". I.e. when weights change because prices change, yesterday's index portfolio continues to be today's index portfolio. Hence a buy and hold strategy is all that is required to replicate index returns under normal circumstances. Note that someone who buys and holds a NIFTY 50 portfolio earns dividends, this should be compared with the NIFTY 50 TR index and not plain NIFTY 50.

When corporate actions take place, the market capitalisation changes and weights have to be adjusted. Rights issues, public issues and mergers all present such problems. Of course, when index set changes take place, the portfolio has to be adjusted and weights get modified. This requires elaborate, and consistently-applied policies. These policies have been the subject of great attention and care at NSE Indices and are fully disclosed to the public.

NIFTY 50 is available from 3 July 1990. The historical data is calculated in an intelligent way, i.e. the index set steadily evolves even through the older years. The historical NIFTY and NIFTY-TR are very useful for researches.

Data for NIFTY 50 and other indices are available on the NSE website under Indices / Statistics

This can, indeed, be done. Is it worth doing? That depends upon the cost and benefit. Calculating the weights, in the ten stocks with the lowest market impact cost, so that the correlation with NIFTY 50 is maximised, is not easy to do. (See Risk structure of Indian stocks by Dr. John Blin of Advance Portfolio Technologies APT - http://www.aptltd.com for a calculation of a 10-stock portfolio which is maximally correlated with NIFTY 50. This is found in the book "The future of fund management in India" edited by Dr. Tushar Waghmare, "Invest India" - Tata McGraw Hill Series, 1997 - http://www.iief.com)

The gains from such an activity are not large. NIFTY 50 is explicitly designed to make it convenient to trade complete index portfolios. This is in contrast with other markets, where indices have arisen before index futures came about, and ways had to be found to trade them. For example, the 500 index was there before index futures came about. When index futures started trading, arbitrageurs had to find ways to trade the index - trading 500 stocks on the floor-based New York Stock Exchange was highly cumbersome. This led to great creativity in finding 250-stock portfolios which correlate well with the 500. In India, there is no need to undergo these kinds of problems. NIFTY 50 is the base of the index futures, and NIFTY 50 is designed to be convenient to trade directly.

In 1998, NSE and CRISIL launched a joint venture named NSE Indices to focus on index management. This pools the index development efforts into a coordinated whole, India's first specialised company focussed upon the index as a core product. In August 2013, CRISIL Limited, erstwhile 49% stake holder in NSE Indices sold its entire stake in NSE Indices to NSE Investments Limited (formerly known as NSE Strategic Investment Corporation Limited), a subsidiary of the National Stock Exchange India Limited and hence NSE Indices has since become wholly owned subsidiary of the NSE Investments Limited (formerly known as NSE Strategic Investment Corporation Limited). Today, the NIFTY 50 is owned and operated by NSE Indices. It is a global phenomenon where an independent company calculates and maintains the index.

No. It's purely coincidental. It was research that led to the choice of 50 stocks as the optimal size of an index in the Indian equity market. One day, a clever leap was made from NSE-50 to ' NIFTY 50'.

The NIFTY 500 is India’s broadbased index of the Indian capital market. The NIFTY 500 represents about 95% of free-float market capitalisation and about 92% of the total turnover on the NSE. The NIFTY 500 is a free-float market capitalisation weighted index. The base date for the index is the calendar year 1994 with the base index value being 1000. Companies in the index are selected based on their market capitalisation and trading interest which is measured by average daily turnover. The index is calculated and disseminated real-time.

NIFTY 50 is the first rung of the largest, highly liquid stocks in India. NIFTY Next 50 is an index built out of the next 50 large, liquid stocks in India. It is not as liquid as the NIFTY 50, which implies that the information in the NIFTY Next 50 is not as noise-free as that of the NIFTY 50. It may be useful to think of the NIFTY 50 and the NIFTY Next 50 as making up the 100 most liquid stocks in India. NIFTY 50 is the front line blue-chips, large and highly liquid stocks. The NIFTY Next 50 is the second rung of growth stocks, which are not as established as those in the NIFTY 50. A stock like Bosch Ltd., which recently (in May 2015) graduated into the NIFTY 50, was in the NIFTY Next 50 prior to this. NIFTY Next 50 can be viewed as an incubator where young growth stocks are found. As with the NIFTY 50, stocks in the NIFTY Next 50 are filtered for liquidity, so they are the most liquid of the stocks excluded from the NIFTY 50. Buying and selling the entire NIFTY Next 50 as a portfolio is feasible. The maintenance of the NIFTY 50 and the NIFTY Next 50 are synchronised so that the two indices will always be disjoint sets; i.e. a stock will never appear in both indices at the same time. Hence it is always meaningful to pool the NIFTY 50 and the NIFTY Next 50 into a composite 100 stock index or portfolio.