When someone asks or thinks about the market, the most important level we think about or check is Sensex or Nifty. When it goes up, we know our portfolio will do better and vice versa. So, these are two examples of widely tracked Indian Index. We are going to learn the basics of Index, their types, how they help us & how they are constructed & then maintained.
This is a 2-part series on – What is Index? Index Types & Index construction or Index computation. So, stay tuned.
What is Index?
An index is generally a broad-based indicator of movement in prices of financial products, commodities, etc. When we say ‘Index’ in the stock market, it represents a statistical measure of changes in prices of various securities in the market.
As the prices of underlying securities are volatile, the stock market index keeps on changing rapidly.
Indices are used widely in capital markets. Apart from some general purpose or overall representative indices, there are many specific indices in use all over the world. NIFTY 50 and SENSEX are the two most popular indices used in India.
Some others for example are – BSE BankEx (sectoral or specific index for the banking sector), BSE Small Cap (broad-based index for companies that are small on market capitalization parameter), NIFTY Dividend Opportunities 50 Index (a strategy-based index), etc.
Types of Index in a Stock Market
Broad Market Indices
A broad-based index is designed to reflect the movement of the entire market. They serve as a benchmark for measuring the performance of the stocks or portfolios such as mutual fund investments.
However, broad market indices are not total market indices. They leave out many small and micro-cap stocks. Broad market indices only include securities with reasonable size and liquidity.
Derivatives based on broad-based indices allow investors to effectively own the same basket of stocks contained in a major index while committing a small amount of money. Example – S&P BSE AllCap index.
Sectoral Indices
Sectoral indices represent indices that are constituted by securities belonging to a specific sector of the market, for example, banking, pharma, telecom, financial services etc. These indices enable investors to make more selective choices of companies to track progress in relation to their respective peer groups.
For instance – NIFTY Bank Index is an index comprising all liquid and large capitalized Indian Banking stocks.
Thematic Indices
Thematic indices are based on themes like emerging markets, alternative energy, fixed income, education, etc. to help investors match their needs to market trends.
Examples – BSE ESG in India, Low Carbon 100 Europe Index of Euronext, S&P BSE India Infrastructure and NSE’s NIFTY Energy Index.
Fixed Income Indices
A Fixed income index measures the performance of the bond market. They are a useful tool for investors to measure and compare the performance of bond portfolios. Fixed income indices are also used for the introduction of Exchange Traded Funds. Examples – NIFTY AAA Ultra Short Duration Bond Index, NIFTY A Long-Term Bond Index, S&P BSE India Sovereign Bond Index.
Blended or Hybrid Indices
As the name suggests, it is an index constituted by two or more indices. The underlying indices may carry same or different weights in the computation of the final index.
Example – The NIFTY 50 Hybrid Short Duration Debt 25:75 Index. It is blended by two different indices namely NIFTY 50 (25% weightage) and NIFTY Short Duration Debt Index (75% weightage).
How is an Index computed?
Basic steps to compute an Index for the stock market are given below –
- Prepare a list of stocks that would constitute the index
- Ascertain price and/or market capitalization for each chosen stock as on a base date
- Assign a base value or initial value of the index as on the base date
Thereafter, the index can be computed at any pre-defined time interval by giving input of changed prices and / or market capitalization data for each stock.
There are two methods that are widely used for calculating indices, described below –
Market-Capitalization Weighted Index
These are the most commonly used indices by the exchanges worldwide. In this method, the number (size) and the price of the stock both are taken into consideration to compute the index.
Market capitalization for each company is computed by multiplying the number of shares issued by that company with the price of the shares.
In this method, an index is impacted by movements in the price of a stock and also by the quantity of the stock.
There are two variations in this method. One considers the total number of shares issued by the company for computation of market capitalization.
Another variation, which is more logical and hence popular too considers the number of shares available for trade in the market (free float market capitalization method). Free float means shares available to trade. So it will not constitute promoters holding or shares pledged for loans.
Price Weighted Index
In this method, the value of an index is calculated on the basis of the company’s stock price. This method gives weight to each security forming the index according to the price per share prevailing in the market.
Hence, stocks with a higher price enjoy more weight and consequently, do have a more significant influence over the performance of the index.
Let’s understand it now by taking an example. Suppose an index is to be computed comprising of two stocks A and B only, using the free float market capitalization method. The base date is selected as January 1, 2000, and base or initial value of the index is set to be 1000.
Over the period, index computation techniques have evolved a lot.
There is a great amount of research work that goes behind the selection of stocks, choice of base year and base value, price intervals to be considered, criteria of inclusion and exclusion of stocks from an index, adjustments to be undertaken on account of corporate events like further issuance of shares by way of bonus or rights issue, a subdivision of shares etc. which impacts the market capitalization of the stock.
The Index Committee specifically constituted by Exchanges for this purpose, meets periodically to review all the indices. The decision on inclusion and exclusion of a particular stock from an Index is taken based upon pre-decided set of certain qualitative and quantitative parameters. For example – market capitalization, trading frequency, average daily trades, average daily turnover, listing history and track record.
In case of a revision in the Index constituents, the announcement of the incoming and outgoing securities is made in advance of the actual implementation.
Most exchanges across the world follow a transparent and well-documented policy for computation of their various indices to make them reliable, understandable and acceptable to various user groups.
