Index & Indices

Market Index

Understanding Sensex & Nifty

We have understood what an exchange is and how we can trade on the same. In this article let’s discuss “market index”. We keep reading in newspapers that Nifty is up or that Sensex is down. Let’s try to understand what these up and down movements actually mean. Nifty and Sensex are the market indices of National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) respectively. The market index is what is most commonly tracked and followed by all market participants to get a broad understanding of general direction of market movement.

Let’s try to understand this through an example. Suppose you want to understand the price movement in real estate sector in a particular city. If a property buyer offered you a high price for a piece of property that you bought last year, and based on the same you conclude that real estate price across the city is trending up, then there is a high possibility that you are wrong. There are different types of properties available in the market: agricultural land, commercial land, residential land, office space for renting, bungalows, flats etc. There are a multitude of reasons why price of any of these types of properties might be increasing/decreasing. Some of the reasons causing price movement might be common to all types of properties and other reasons might be affecting only specific property type. In general, when population is increasing in a locality and land is becoming scarce, prices of all kinds of properties go up. So this is a common factor affecting all kinds of properties. But there might be a situation where demand and price of commercial properties are decreasing because companies are shifting their base out of the city, while demand and price of residential flats are increasing because people, whose personal income is increasing, are buying second homes. Thus, if we want to conclude something about the real estate market in a city, we cannot do that just by looking at price movements in a single locality or in a single property type. However if we create a representative basket which includes some properties from all these types and from different location across the city, then we will be able to better observe general price trends and conclude direction of price movement in the sector.

A market index serves as a benchmark that allows us to understand general price movement of stocks on the exchange. As discussed in the first article, many companies are listed on the stock exchange. If we just look at price movement of one company to decide general trend in price movement across market, our conclusion will most likely be incorrect. First we will need to create a basket of sample stocks as was suggested in the earlier example. Including most frequently traded stocks from different sectors of the market like banking, pharma, IT, metals etc. will give best results. Once the basket is created we can observe the price movement of the stocks within, to conclude the general price trend of the market.

Nifty is a sample of 50  listed and frequently traded stocks on NSE, selected from across different sectors. Similarly, Sensex is a sample of 30 stocks from across different sectors all listed on BSE.

Read on to understand what an index is and how it is  constructed.

What is an Index?

The representative sample

We have discussed what a market index represents and why we track it. In this post let’s learn more about the market index.

The term index usually refers to a basket of some finite assets (stocks/bonds/commodities etc) which as a group forms the best representation of the space in which many similar assets lie. Let’s say we want to create an index to represent Indian IT industry. As per our definition of index, this should be a basket of IT companies that best represent the IT sector. There are many IT companies listed on the exchange, so the natural question is which companies should be selected to be included in the basket? It’s important to define some basic terms at this point

Shares Outstanding = Total number of shares issued by the company

Market Cap = Current Price * Shares Outstanding
(This tells me what is the current value of a company)

Suppose a company X has issued 100 shares and the current price of each share is Rs 10, then the market cap of company X will be Rs 1,000. It means that the total value of the company (cumulative value of all shares) is Rs 1,000. Each listed company in IT sector will have its own market cap/value. If we add all these market caps, we will get the total market cap of IT sector ie combined value of all the listed companies in the IT sector.

Let’s revert to the question of selecting stocks for our Index. Let’s say there are 1000 companies in the IT sector. 10 companies, out of 1000, are very big and represent almost 90 percent of the total market cap of the sector. So the combined market cap of the other 990 companies will amount to only 10% of the sector market cap. Since 10 companies represent most of the market cap of the sector, we could just select these 10 to form a representative basket of the IT industry.

Suppose I want to invest in this IT basket and I have Rs 1000. If I decide to invest equally in all the 10 stocks, I will end up buying Rs.100 worth of shares of each one of these 10 stocks. Let’s assume Infosys is one of the stocks that I hold and I have Rs.100 worth of the company’s shares. So the company has a weightage of 10% (100/1000) of my investment amount.  Stock weightage is equal to value of investment in the stock divided by the total value of all investment. As I invested equally in all the 10 stocks, weightage of each of the stock in my portfolio is 10%.

Let’s assume that at the time of investment each share of Infosys cost Rs.50. Since I invested Rs.100 into the stock I would have got 2 (100/50) shares. Similarly with an investment of Rs.100 in each stock, I would have bought some fixed number of shares of each company.  Suppose after 2 days prices of all stocks except Infosys’s price remains unchanged. So leaving out the value of Infosys, the balance investment is still worth Rs.900. If the price of Infosys has shot upto Rs.90 from Rs.50 over the last 2 days, my investment in that company will now be worth Rs.180 (90 * 2 shares). Total value of investment of all 10 stocks would be Rs.1080 (900+180). Please recall we defined weight of each stock in the portfolio as value of investment in the stock divided by the total value of all investment. Hence weight of Infosys will now be 180/1080 = 16.67%. To make up for the increase in weight of one stock, weightage of all other stocks would have dropped down to 100/1080 = 9.26%.

The important takeaway from this example is that when we create an index or buy a basket, number of shares of each stock remains constant, however weightage of each stock does not. Weightage represents the portion of total value represented by a single stock and as the stock price changes everyday, weights do too. Let’s continue with our example in the next post.

What is an Index? (ii)

Impact of daily price changes on portfolio value

In the previous post we learnt about terms like market cap and shares outstanding. We also discussed how stocks can be selected to be included in an index and how in a basket of stocks though number of shares remains constant, weights keep changing due to price change.  

Let’s continue with the same example of IT industry.  We had selected 10 stocks, representing 90% of the total market cap of IT industry, to be included in our basket/index.  Now suppose instead of 10 stocks we want to retain only 5 stocks in an equal weighted basket. Weight of each stock would then be 20% and a Rs.1000 investment in this basket would result in Rs.200 investment in each stock.   

Let’s assume instead of equal weights, I assign different weights to the stocks and allocate 30% weight each to 3 stocks and 5% each to 2 other stocks. If I now invest Rs.1000 in the index, Rs.300 each will be allocated to the stocks with 30% weightage and Rs.50 each to 2 stocks with 5% weightage. Lets again recall that stock weightage is equal to value of investment in the stock divided by the total value of all investment.

Let’s assume you invest Rs 5000 in an equi-weighted index of 5 stocks. Each stock will have a weight of 20% at the time of investment and will be allocated Rs 1000. Let’s see what happens as the share prices of stocks change on subsequent days.

Investment Day

StockShare priceInitial investmentSharesValue of investment (share price * shares)Weight (Total value / individual value)
Value of investment5000100%
A100100010100020%
B100100010100020%
C20010005100020%
D20010005100020%
E50010002100020%

Investment Day +1 (Next day, prices of all the stocks will change, but the no of shares will remain same) 

StockShare PriceInitial InvestmentSharesValue of Investment
(Share price * Shares)
Weight
(Total Value/Individual Value)
Value of Investment6050100%
A120100010120020%
B150100010150025%
C20010005100017%
D25010005125021%
E55010002110018%

Investment Day +2 (prices will change again, but the no of shares bought will still remain same)

StockShare PriceInitial InvestmentSharesValue of Investment
(Share price * Shares)
Weight
(Total Value/Individual Value)
Value of Investment7100100%
A150100010150021%
B180100010180025%
C22010005110015%
D30010005150021%
60060010002120017%

As can be observed, after we bought the index price of stocks and because of that weights of stocks within the basket kept changing. However number of shares will always remain constant. On day 1, at the time of investment, value of my portfolio was Rs 5000. On day 2, it changed to Rs 6050 and on Day 3 it changed to Rs 7100.

To understand how to calculate profits and arrive at an Index value, read on.

 

Calculating Index Value

Simplifying return analysis

Let’s continue with the same examples that we used in the previous articles. We started out by creating an index for the Indian IT sector. We then learnt about market cap and shares outstanding. We then learnt about which stocks can be included in an index. We also discussed weightage of stock in an index/basket and how due to price change weights keep changing but absolute number of shares remain the same.

We also considered another example of buying a basket where Rs.5000 was invested in 5 stocks. We saw how the number of shares purchased were calculated and how the total value of investment changed due to change in stock price. On the day of investment, value of the total investment was Rs 5000. Next day, the value changed to Rs 6050 and the day after that, it changed to Rs 7100. In this post, let’s try to understand how the final Index value is calculated and how it should be interpreted.

While calculating an index value, we want to see how investment value has been moving on a daily basis compared to the base value. In our example the base value is Rs 5000 and we want to understand how much returns we have earned on this amount. If we change the scale and say that 5000 = 100, then 6050 would be (100/5000)*6050. This is basic unitary mathematics. The below table summarizes the calculation of Index values for subsequent days, when we change the initial base value to 100 from 5000.

DayInvestment ValueIndex CalculationIndex Value
Investment Day5000(100/5000)*5000100
Investment Day + 16050(100/5000)*6050121
Investment Day + 27100(100/5000)*7100142

Now we are clear about how an index is created, calculated and interpreted. Whenever creating an index, fix the initial value to a base number and then track progress of the investment by comparing it to the base value. Sensex has a base value of 100, fixed in 1978-79 and now it has increased to more than 25000. Similarly, Nifty has a base value of 1000, fixed on 3rd Nov’95 and has crossed more than 7500. You can easily calculate the returns that both the indices have generated, since their inception. On day one our Index value was 100 and on day two it increased to 121. Hence one day index return was 21% which can be verified by the following calculation (6050-5000)/5000 = 21%. At the end of day two our index value stood at 142 and this allows us to understand that we have made 42% returns over the previous two days. This can also be verified by the following calculation (7100-5000)/5000 = 42%.

It is prudent to create an index for your investments. Index creation allows one to easily understand returns and follow & track investments. Smallcase platform makes available easily trackable custom indices for your portfolio/investment. It’s time you upgrade the way you invest.

Types of Indices

Garnishing the portfolio

In the previous article we learnt how to create, track and understand an index. This article will discuss various types of indices one can create using different weighting methodologies. There are 3 different weighting schemes that we can use:

1. Price Weighted :  stocks in the index are weighted based on their prices,  stock with the highest price will have the highest weight

2. Market Cap Weighted : stocks in the index are weighted based on their market capitalization, stock with highest market cap has the highest weight

3. Equal Weighted : stocks in the index are equally weighted

Suppose you decide to invest Rs 5000 in 5 stocks – AA, BB, CC, DD, EE.

Initially at the time of investing on Day 1, price and market cap of stocks AA,BB,CC,DD and EE are Rs 10, 20, 30, 40 & 50 and Rs 2000, 3000, 15000, 10000, 5000 respectively. Let’s assume at the end of day 2,  prices of stocks BB and EE have increased by 50%, while prices of all other stocks remain constant. The tables below explain how value of your investment will change each day depending on the weighing scheme.

1. Price Weighted

Day 1

Stock
(A)
Price
(B)
No. of Shares
(C)
Weight
(D=B/150)
Value of Investment
(E=D*5000)
Total150100%5000.0
AA1016.7%333.3
BB20113.3%666.7
CC30120%1000.0
DD40126.7%1333.3
EE50133.3%1666.7

Day 2

Stock
(A)
Price
(B')
No. of Shares
(C)
New Weight
(D=B/180)
Value of Investment
(E'=E*B'/B)
Total180102.8%6166.7
AA1015.6%333.3
BB30116.7%1000.0
CC30116.7%1000.0
DD40122.2%1333.3
EE75141.7%2500.0

2. Market Cap Weighted

Day 1

Stock
(A)
Price
(B)
Market Cap (INR)
(C)
No. of Shares
(D=F/B)
Weight
(E=C/35000)
Value of Investment
(F=E*5000)
Total35000100%5000.0
AA10200028.575.7%285.7
BB20300021.438.6%428.6
CC301500071.4342.9%2142.9
DD401000035.7128.6%1428.6
EE50500014.2914.3%714.3

Day 2

Stock
(A)
Price
(B)
No. of Shares
(C)
New Weight
(E=C/5928.57)
Value of Investment
(E=B*C)
Total100%5571.43
AA1028.575.1%285.71
BB3021.4311.5%642.86
CC3071.4338.5%2142.86
DD4035.7125.6%1428.57
EE7514.2919.2%1071.43

3. Equal Weighted

Day 1

Stock
(A)
Price
(B)
No. of Shares
(C=E/B)
Weight
(D)
Value of Investment
(E=D*5000)
Total150100%5000.0
AA10100.020%1000.0
BB2050.020%1000.0
CC3033.320%1000.0
DD4025.020%1000.0
EE5020.020%1000.0

Day 2

Stock
(A)
Price
(B)
No. of Shares
(C)
New Weight
(D=E/6000)
Value of Investment
(E=B*C)
Total150100%6000.0
AA10100.016.7%1000.0
BB3050.025.0%1500.0
CC3033.316.7%1000.0
DD4025.016.7%1000.0
EE7520.025.0%1500.0

At end of day  2 it be can see that the value of your investment is different, in each one of the above weighting scheme. In our example, price weighted methodology generated maximum return. However the outcome would have been completely different had the stock price fluctuated in some other manner.

At smallcase, you can easily pick the desired weighting scheme or use the one recommended by our platform. Picking the right weighting scheme is very important, as it can significantly impact your returns.

Sectoral Indices

In our previous article we talked about various types of indices one can create, using different weighting schemes. In this article, let’s understand a sector Index.

As the name suggests, sector index/benchmark tracks the performance of a particular sector. Let’s take the example of BSE AUTO Index. It is used to track the performance of auto sector companies listed on BSE. As discussed in our initial articles on index, an index should comprise companies from each segment of the sector to remove all biases. You can quickly revise our examples of real estate index or IT sector index, for better understanding of the same. In the case of BSE AUTO index, it includes companies from all segments of Auto sector: auto parts manufacturers, tyre manufactures, 4 wheeler manufacturers, 2 wheeler manufacturers etc. The objective of creating the index was to put together the best possible representative sample of auto stocks and then track them all together through an index value. Once a representative sample is selected, generally market cap weighting scheme is used to create indices. BSE Auto index allows us to track the happenings of the Indian auto sector as most of the Indian auto companies are listed on BSE. If we want to see what is happening to Auto sector in Germany or USA, we can follow the auto sector indices of respective country exchanges. We can also create a global auto index by considering all the auto companies listed on various exchanges. A select group of companies that best represent the global auto sector universe can then be short-listed to form a basket.

Let’s consider one more example and talk about Nifty Media Index. It’s a Media sector index and represents media companies listed on NSE. As discussed, first step is to select companies from all segments of the sector to make the best possible representative sample. Nifty Media includes broadcasters, printers & publishers, film production houses and other segments of the Media sector. Once companies are selected, weights are decided based on the market cap weighting methodology. The company with highest market cap will have the highest weight. At the beginning of Jun’15, index value of Nifty Media was 2108. The same value at the end of Jul’15 was 2452. Using this we can quickly say that Media sector generated a return of 16.3% (2452/2108-1), in these two months. Similarly, we can calculate the returns generated by other sectors and compare them with each other to know which sector is performing the best.

Generally, sector indices based on companies listed on BSE, have BSE as their prefix: BSE Auto, BSE IT, BSE Metals etc. Sector indices based on companies listed on NSE, have Nifty as their prefix: Nifty Pharma, Nifty Auto, Nifty Realty etc. Tracking these tailor-made, easy to use indices enables an individual to quickly ascertain a sector’s health, its historical performance compared to other sectors, and helps him make a better investment decision. Let’s now learn and understand about custom indices.

Benchmarking

Point of reference matters - Einstein

A custom index refers to an index tailored as per one’s specific needs and expectations. Although there are many readymade/standard indices available on stock exchanges, they might not always fulfil every individual’s need. To understand the meaning and applicability of custom indices, first we need to understand what we mean by benchmark/benchmarking.

There are always two ways of measuring performance: absolute and relative. Suppose you are participating in a 100m running race. After completing the race you have been told that you took 30 seconds to complete the circuit. This is an example of absolute measurement. However this piece of information does not allow you to understand whether you won the race. Hence it is not a useful way of measuring performance. But if you are told that you finished first, then you understand that your performance was good. Similarly if you are told that your timing was just 2 seconds slower than the race record, this can also be interpreted as good performance. These are examples of relative measurement. In the first case, your performance was measured relative to that of other participants and in second case measurement was relative to previous record.

In finance and investment world, performances are generally measured in relative terms and compared to a benchmark. The benchmark is generally an index, relative to which an an individual stock or basket of stocks performance is measured. Let’s say I define Nifty as my benchmark and invest in a basket of 5 stocks, called “my basket”. Suppose after a month, Nifty has generated a return of 5% whereas my basket has appreciated by 7%, then one can conclude that my basket outperformed Nifty by 2% (7% – 5%).

Let’s consider another example. I now want to invest in a few IT companies and over a period of time compare their performance with that of IT sector in general. Our post on “Sector Indices”, informed us that Nifty IT sector index is a good way of tracking the performance of Indian IT sector. Hence I define Nifty IT sector as my benchmark and invest in a basket of IT stocks that I feel will perform well going forward.  After few days, I see that my investment has generated a return of 10%, however my benchmark Nifty IT index has returned 15% during the same period confirming that my IT basket has underperformed the sector index. In other words the stocks that I bought performed poorly when compared to the IT sector in general.

It is prudent to always define a benchmark to measure the performance of your investments. If you are investments are in a specific sector then a sector index might be a good benchmark. However if your investments are sector agnostic, then broader indices like Nifty and Sensex might be good benchmarks.

Custom Indices

The smallcase way of investing

In our previous article, we discussed benchmarks in detail and acquainted ourselves with the concept of custom indices. Let’s discuss custom indices in some detail now. Although there are many ready-made/standard indices available on stock exchanges, they might not always fulfil investor’s need. Hence investors might want to build their own custom indices.

Suppose you believe that it is the right time to invest in pharmaceutical companies and want to buy select companies in the sector. The smallcase platform makes available a basket/smallcase/index called Pharmacase that allows you to take position in representative group of companies from the pharma sector. Pharmacase consists of 5 stocks  (AA,BB,CC,DD,EE) and has an equal weighting scheme. We know that in an equal weighting scheme, all stocks in the portfolio have equal weights; hence each stock in Pharmacase has a weight of 20%. However being a prudent investor you have done your research and believe that stocks BB and DD will perform better than other stocks in Pharmacase and you want to assign higher weights to these stocks. Your preference is to allocate 35% weight each to BB & DD and distribute the remaining 30% weight amongst the remaining 3 stocks. Please refer to our article on index to refresh your understanding about weights and weighting schemes.

So you now customize the index by assigning higher weights to stocks BB & DD and also decide to use Pharmacase as your benchmark. Assuming a total investment of Rs.100 and price of each stock to be Rs.10, the below table illustrates how the value of your portfolio will change, relative to the value of Pharmacase, if only prices of stocks BB and DD rise by Rs.1 after one day.

Pharmacase, Investment Day

Stock
(A)
Price
(B)
No. of Shares
(C)
Weight
(D=B*C/Sum[B*C])
Value of Investment
(E=D*100)
Total100
=sum(B*C)
100%100.0
AA10220.0%20.0
BB10220.0%20.0
CC10220.0%20.0
DD10220.0%20.0
EE10220.0%20.0

Pharmacase, Investment Day +1

Stock
(A)
Price
(B)
No. of Shares
(C)
Weight
(D=B*C/sum[B*C])
Value of Investment
(E=B*C)
Total150104
=sum(B*C)
100%104.0
AA10219.2%20.0
BB11221.2%22.0
CC10219.2%20.0
DD11221.2%22.0
EE10219.2%20.0

Custom Index, Investment Day

Stock
(A)
Price
(B)
No. of Shares
(C=D*100/B)
Weight
(D)
Value of Investment
(E=B*C)
Total100
=sum(B*C)
100%100.0
AA10110.0%10.0
BB103.535.0%35.0
CC10110.0%10.0
DD103.535.0%35.0
EE10110.0%10.0

Custom Index, Investment Day +1

Stock
(A)
Price
(B)
No. of Shares
(C=D*100/B)
Weight
(D)
Value of Investment
(E=B*C)
Total107
=sum(B*C)
100%107.0
AA1019.3%10.0
BB113.536.0%38.5
CC1019.3%10.0
DD113.536.0%38.5
EE1019.3%10.0

As can be seen from the calculations above, had you followed the trend and invested in Pharmacase, at the end of day 1 you would have ended up with Rs.104. But by customizing the index, you ended day 1 with Rs.107.  You outperformed the benchmark by 3% (7%-4%). Your choices made you richer by an additional 3%. In just a few clicks, you can create and customise your own index on Smallcase. Power lies in your hand, use it wisely.