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Macronomics: Your Guide to the Market Index

Deepak Shenoy9 min read
Quick Facts
What is "Macronomics: Your Guide to the Market Index" about?
What category is this article in?
Premium
Who wrote this article?
Deepak Shenoy, Capitalmind's research team.
When was this article published?
Published 22 November 2013.
How long does this article take to read?
9 min read
What does the "What is an Index?" section say?
We know how stocks have performed - simply compare today’s price over yesterday’s price. If we need to find out how the stock market, as a whole, performed, we need a way to measure it. A simple metric would be to take a small set of representative stocks and value them every day, and their movement is like a barometer for the market.
What does the "The Market Cap Weighting" section say?
While it’s great to have the index as a barometer, it only makes sense if you can invest in the index easily. The reason we don’t take all the stocks in the exchange is because no one can replicate the index performance in their portfolio easily! (Imaging buying 4,000 stocks).
What does the "Indexes in India" section say?
India uses free-float market-cap weighted indexes, for the most part. (They didn’t, but they changed) The two famous ones are:
What does the "Rebalancing and Reweighting" section say?
If free-floats change, an index strategy must rebalance its portfolio. This is not often - but it does create complications.
What does the "Dividends Add To Your Return" section say?
When a stock gives a dividend it might go up suddenly, only to retreat after the date of the dividend. To avoid such bumps coming into the index, what is done is to remove the effect of the dividend while calculating the index values.
What does the "Can be Too Heavy" section say?
India’s market cap based indexes favour a few big stocks. More than 68% of the IT Index is in two stocks: Infosys and TCS. HDFC Bank and ICICI Bank form nearly 60% of the bank index. If you become too dependant on a stock, you lose the benefit that indexing gives you: diversification.
What does the "Chasing the Index: Buying Stocks" section say?
You could of course simply buy stocks in the same proportion as the index. This involves a large sum of money to do an exact replica, because you can’t buy fractional stocks, so if the formula says 1.4 shares of ONGC, you buy one and hope it doesn’t cause too much of a tracking error.
What does the "Buying ETFs" section say?
Most actively managed mutual funds will benchmark their stocks with an Index. It could be the BSE 200, or the NSE Nifty or such. But in the US, it’s been found that the mutual fund costs - between 2% to 5% a year in the US - eat into returns so much that most funds underperform the broad indexes.
What does the "The Future Route" section say?
The other way is to buy Nifty futures and roll them over every month. You would buy a November Nifty future, and at the end of November, sell that and buy a December future and so on. There is a cost to the rollover, since the December future might be trading higher than the November future. This premium is called the “carry”, and typically indicates the cost of money.
What does the "Other Ways to Get Indexed Returns" section say?
Creating indexes is easy - all you need is a thought process. There can be an earnings weighted index, or an EPS growth weighted index for the fundamental players. You could construct a “momentum” index of fast movers. There are already dividend indexes out there. You can’t invest in all of them, but you can create portfolios that mimic their returns.

This week we talk about indexes, specifically on the stock market.

What is an Index?

We know how stocks have performed - simply compare today’s price over yesterday’s price. If we need to find out how the stock market, as a whole, performed, we need a way to measure it. A simple metric would be to take a small set of representative stocks and value them every day, and their movement is like a barometer for the market.

These stocks form the index. Each stock has a weight in the index, based on its importance relative to the other stocks in the same index. There are multiple ways to weigh stocks:

  • Pure price. This is what the Dow Jones Industrial Average does, and if a stock goes up in price, the index will go up. Obviously this is a silly way to do things, because if a stock goes through a split (get 2 shares for 1), the price will halve and thus, the stock’s weight comes down?

  • Market Cap: You weigh stocks on their total market capitalization. This is most commonly used.

  • Other metrics: There are revenue-weighted indexes, profit-weighted indexes and so on.

  • Equal weighted. Playing no favourites has its advantages.

If you weight stocks based on a metric, then every time the weights change, you have to “rebalance” the stocks in your index appropriately.

The Market Cap Weighting

While it’s great to have the index as a barometer, it only makes sense if you can invest in the index easily. The reason we don’t take all the stocks in the exchange is because no one can replicate the index performance in their portfolio easily! (Imaging buying 4,000 stocks).

To be able to buy stocks in a market-cap weighted index, you would buy stocks in the proportion of their weight, or their market cap. If one stock goes up 1%, then you don’t have to do anything, since it would have gone up 1% in market-cap, and it would have gone up 1% in your portfolio. This is one of the reason market-cap weighted indexes are very popular: there is no requirement to rebalance.

But they come with problems. A stock like Wipro has about 75% of shares owned by the promoter. Some stocks have 90% owned by the government. These stocks might have a massive market capitalization but if shares are not freely available, then one can’t buy in a large enough quantity.

To cover for this, indexes are weighted based on the “free float” of the stock, that is, non-promoter-owned or locked.

If you assume Wipro is in the Nifty, and it’s market-cap is Rs. 80,000 cr., with 25% “free-float”, then only 20,000 cr. will be considered for the weighting calculation. Other stocks’ free-float market caps are similarly ascertained and then the weights are calculated.

Indexes in India

India uses free-float market-cap weighted indexes, for the most part. (They didn’t, but they changed) The two famous ones are:

  • CNX Nifty - the top 50 stocks, by free-float market-cap, on the NSE.

  • Sensex - the top 30 stocks, by free-float market-cap, on the BSE.

There are other broad indexes, like:

  • CNX Nifty Junior - The “next 50” - that is, stocks 51-100 on the NSE.

  • BSE and NSE 200: the Top 200 stocks

  • CNX Midcap - the best of the “smaller” stocks.

And then, there are sectoral and thematic indexes, like:

  • Bank Nifty - Banking stocks on the NSE

  • CNX Realty - Real estate stocks

  • Shariah Index - stocks that conform to the Shariah rules.

There are tons of indexes in the stock markets. (See the NSE and BSE pages). And then there are bond indexes (for the bond markets), commodity indexes and so on.

There’s even a Dollar based index - basically if you took exposure to the Nifty in USD, then how much would your investment be worth today, in USD, over a long term. Turns out it’s a little disappointing in the recent few years:

(The Rupee had appreciated to Rs. 39 in 2007 which gave the Defty outperformance. The rupee has now fallen to Rs. 62.5 to a dollar, and much of that depreciation is in the last two years.) The 10 year return, even in the Defty, is still a compounded 10.7% a year (plus dividends!).

Rebalancing and Reweighting

If free-floats change, an index strategy must rebalance its portfolio. This is not often - but it does create complications.

In addition, since the “top 30” stocks can change, the constituents of the Sensex or the Nifty will change. Stocks could go out and go in. See how the Sensex has evolved in 21 years:

Only 9 of the original 30 survive. This means the long term buy-and-hold concept might not really apply!

Dividends Add To Your Return

When a stock gives a dividend it might go up suddenly, only to retreat after the date of the dividend. To avoid such bumps coming into the index, what is done is to remove the effect of the dividend while calculating the index values.

Thus, if you own the stocks underlying the index, the return you make is higher than the index move itself (which ignores dividends).

To find out what you would have gotten if you had invested, including dividends, the NSE publishes a “Total Return Index”.

You don’t get TRI data for any index other than the Nifty, unfortunately.

Can be Too Heavy

India’s market cap based indexes favour a few big stocks. More than 68% of the IT Index is in two stocks: Infosys and TCS. HDFC Bank and ICICI Bank form nearly 60% of the bank index. If you become too dependant on a stock, you lose the benefit that indexing gives you: diversification.

Let’s now see what it takes to build a portfolio that will give you as much return as the index. We have to aim for “positive tracking error” - that is, give me better returns than the Nifty, but don’t give me worse returns at any time.

Chasing the Index: Buying Stocks

You could of course simply buy stocks in the same proportion as the index. This involves a large sum of money to do an exact replica, because you can’t buy fractional stocks, so if the formula says 1.4 shares of ONGC, you buy one and hope it doesn’t cause too much of a tracking error.

But this is

the only way you can buy into indexes that don’t have futures or ETFs on them.

Buying ETFs

Most actively managed mutual funds will benchmark their stocks with an Index. It could be the BSE 200, or the NSE Nifty or such. But in the US, it’s been found that the mutual fund costs - between 2% to 5% a year in the US - eat into returns so much that most funds underperform the broad indexes.

Now buying into an index is a no-brainer, so a mutual fund that buys the index can have a very low cost and come close to beating the index. Additionally if people can buy your units on an exchange directly (See Exchange Traded Funds, or ETFs) there is no distribution cost which makes it even cheaper.

You can then buy into an index by buying an index fund or index ETF. An example product on the NSE is the NiftyBeEs, a product that mirrors the NSE Nifty. This trades as: 1 NiftyBeEs= 1/10th the Nifty Index.

An ETF will beat the Nifty, in that the Nifty stocks give dividends which accrue to the ETF. Nifty doesn’t include those dividends, so you can assume there will be a 2% outperfomance every year. (Assuming 2% is the dividend yield).

The Future Route

The other way is to buy Nifty futures and roll them over every month. You would buy a November Nifty future, and at the end of November, sell that and buy a December future and so on. There is a cost to the rollover, since the December future might be trading higher than the November future. This premium is called the “carry”, and typically indicates the cost of money.

For instance, on this day, the Nifty November future is at 6132, and the December future is at 6186. This gives you a 0.8% premium for the December future, which you lose on the rollover. This 0.8% is the carry for 1.2 months, the time between today and the December expiry.

However, you don’t have to put the full cash down on the future; you might need to pay just 10% of the trade value, and even that can be in an interest earning instrument. Considering market rates are around 9% per year, the 1.2 months will give you the 0.8% as interest.

I’ve plotted the above routes and it shows you that the futures method has been superior.

NIfty through Futures

Note: Assumes one unit of Nifty (10 units of Nifty bees) rolled over on the closing price of every month. Nifty Bees includes Rs. 175 per Nifty as dividend, since Jan 2010. Assumed 8% interest on 85% of the money in the futures contract, rest goes as margin.

You’ll find that the futures strategy has done well, but that’s because in many of the months in the last three years, index futures traded at a discount - that is, a further month future was available cheaper than the current month one.

The downside is that many indexes have no futures, like CNX Junior. For that you have to take the JuniorBeEs ETF. But if you want to invest in a broader index like the CNX 500, you have no ETF or future to work with; you have to build the indexes on your own.

Other Ways to Get Indexed Returns

Creating indexes is easy - all you need is a thought process. There can be an earnings weighted index, or an EPS growth weighted index for the fundamental players. You could construct a “momentum” index of fast movers. There are already dividend indexes out there. You can’t invest in all of them, but you can create portfolios that mimic their returns.

In the next letter I’ll speak about how you can use an “Equal Weighted Index” to your advantage, without involving futures or options or anything more complicated than buying stocks.