Index fund Investments - Continued

What constitutes the index? How is the index prepared? Why is it required? Is it really efficient?

In this article, I’ll try to give some fundamentals about the index and how it has been changing over the period of time.

A stock market index like Sensex or Nifty is used to capture the behaviour of the overall equity market. By overall equity market, it is implied that the index will reflect the status of the equity market of that particular country. A GOOD index will truly reflect the overall picture of the country specific stock market. Hence, it becomes important that the index is constituted by the so-called BEST available companies.

A mixture of these BEST companies from different sectors ensures that DIVERSIFICATION is taken care of. On any given day, there will be some loosing stocks that will give negative returns, and some winning stocks that will give positive returns. A good index should be constituted in such a way, that it should cancel out the most common positives and negatives across different constituent stocks and come out with a NET value, which can be either positive or negative. If this value is significantly positive, then it is claimed that the country’s equity markets are doing good. If it is significantly negative, it is said that the country’s equity market is doing bad. If the Index value does not change significantly, i.e. stays near about 0% change, it is said to be stagnant. As a general principle, more than +1% or -1% change implies a significant change in market.

How are the stocks selected for index?

There are almost 10,000 stocks listed on BSE. How does BSE decide which 30 should be there in the SENSEX? Or how does NSE decided which 50 stocks should be in NIFTY? This takes us to market value of a company. When a company is listed on the stock exchange, it comes out with a specific no. of shares. Just for an example, let’s say WIPRO listed on the stock exchange with 100 million shares. It means that the company was divided into a total of 100 million parts or what we call shares. Out of this, suppose 85% were retained by the chairman, Mr. Azim Premji and remaining 15% were offered to public. So Azim Premji will keep 85 million shares with him and sell off remaining 15 million shares to public (through IPO). The company is listed, the trading begins and the price starts to change. At any given point of time, the value of the company will be (total no. of shares * Market Price per share). So for Wipro having a total of 100 million shares, and suppose today’s closing price for Wipro was 600 Rs., then the total MARKET VALUE of the company will be 100 million * 600 = 600000 million Rs. The no. of shares usually stays constant (except for some corporate actions), but the share prices change every day. Hence the market value changes everyday.

The exchanges keep calculating the market values of all the companies listed on it. After regular intervals, it generates a list of top 30 (Sensex) or top 50 (Nifty) companies, ranks them in the order of their market value or market capitalization. Let’s take the example of BSE. Let’s say TATA POWER is already in BSE Sensex. However, in the recent market value calculation, if Tata Power ranks 31^st or lower, then it will be taken out of Sensex. Another company that will have a better market value will be used to replace it. In essence, at any given point of time, Sensex will have top 30 companies, in terms of their overall MARKET VALUE. It is left to the exchanges to decide how frequently they replace companies.

Have a look at the following changes that have happened in BSE Sensex companies:

Date	Existing Company	Replaced by (New Company)
01.01.1986	Bombay Burmah	Voltas
	Asian Cables	Peico
	Crompton Greaves	Premier Auto.
	Scinda	G.E.Shipping
03.08.1992	Zenith Ltd.	Bharat Forge
19.08.1996	Ballarpur Inds.	Arvind Mills
	Bharat Forge	Bajaj Auto
	Bombay Dyeing	BHEL
	Ceat Tyres	BSES
	Century Text.	Colgate
	GSFC	Guj. Amb. Cement
	Hind. Motors	HPCL
	Indian Organic	ICICI
	Indian Rayon	IDBI
	Kirloskar Cummins	IPCL
	Mukand Iron	MTNL
	Phlips	Ranbaxy Lab.
	Premier Auto	State Bank of India
	Siemens	Steel Authority of India
	Voltas	Tata Chem
16.11.1998	Arvind Mills	Castrol
	G. E. Shipping	Infosys Technologies
	IPCL	NIIT Ltd.
	Steel Authority of India	Novartis
10.04.2000	I.D.B.I	Dr. Reddy’s Laboratories
	Indian Hotels	Reliance Petroleum
	Tata Chem	Satyam Computers
	Tata Power	Zee Telefilms
08.01.2001	Novartis	Cipla Ltd.
07.01.2002	NIIT Ltd.	HCL Technologies
	Mahindra & Mahindra	Hero Honda Motors Ltd.
31.05.2002	ICICI Ltd.	ICICI Bank Ltd.
10.10.2002	Reliance Petroleum Ltd.	HDFC Ltd.
10.11.2003	Castrol India Ltd.	Bharti-Tele-Ventures Ltd.
	Colgate Palomive (India) Ltd.	HDFC Bank Ltd.
	Glaxo Smithkline Pharma. Ltd.	ONGC Ltd.
	HCL Technologies Ltd.	Tata Power Company Ltd.
	Nestle (India) Ltd.	Wipro Ltd.
19.05.2004	Larsen & Toubro Ltd.	Maruti Udyog Ltd.
27.09.2004	Mahanagar Telephone Nigam Ltd.	Larsen & Toubro Ltd.
06.06.2005	Hindustan Petroleum Corp Ltd.	National Thermal Power Corpn. Ltd.
	Zee Telefilms Ltd.	Tata Consultancy Services Ltd.
12.06.2006	Tata Power Ltd.	Reliance Communiation Ventures Ltd.

Interesting to note the following:

1) Tata Power was in Sensex till 10/04/2000. Then it was replaced by Zee Telefilms. After that, on 10/11/2003, HCL was replaced and Tata Power was back in Sensex again. On 12/06/2006, Tata Power was kicked out again by Reliance Communications.

2) Ballarpur Industries was kicked out of Sensex on 19/08/2006. Till date it is out of Sensex. Same was the case with Premier Auto, Pieco, Mukund Iron and few more.

3) Then there are others like Tata Steel and ACC, which are there in the Sensex since the beginning and holding onto their positions.

Here is the list of changes in Sensex.

Now comes the interesting point: TATA Steel and TATA Power, both belonging to the same business house of TATA’s. Still only one manages to keep itself in index and other is in and out regularly. Other industries of TATA are NOT able to make it to the index. The above 3 points shows how wrong we can be in terms of understanding and differentiating GOOD v/s BAD companies. Ballarpur, Novartis, Mukund Iron, Scinda, Ceat, Peico, etc etc. after being kicked out were never able to make it back again. If you had invested in these companies just by thinking that they are part of index so they are good, you would have been wrong. Though you may have not lost your investment on some of these companies because they are still in business, but you wouldn’t have been able to make the maximum profits.

This also shows how dangerous it is to invest in individual stocks. What has happened to Mukund Iron? Does it still exist? I could not find this stock name on BSE website. Though once a part of Sensex, Mukund Iron no longer exists. If you had invested in Mukund Iron thinking it to be a good company, you would have been in loss. There is nothing called a GOOD Company or a BAD company – it’s just a matter of time during which a company is GOOD or BAD.

How does index change it’s value everyday?

Suppose an index contains two stocks A and B. A has a market capitalisation of Rs.1000 crore and B has a market capitalisation of Rs.3000 crore. Then a weight of ¼ is attachd to movements in A and 3/4 to movements in B. This is known as weighted averaging and is calculated as follows:

Total of two companies: 1000 + 3000 = 4000.

Weighted average of A = (Value of A)/(Total of 2 companies) = 1000/4000 = ¼

Hence, if there is a 10% increase in A and a 5% decrease in B, the index value will change by (+10%)*1/4 + (-5%)*3/4 = -1.3%.

Hence, the higher the value of a company, the higher it’s power to affect the index value. The same calculation can be extended to 30 or 50 stocks and similar calculations are done for every single price change in the constituent stocks of Sensex, Nifty or other indices. This shows the benefit of investments in Index. A big mixed group of companies mean that the fluctuations are less, negatives get cancelled by positives and you always go with the market.

Are Indices Efficient?

Well, that depends upon the exchanges that constitute the stocks comprising indices and how frequently they change them. The more frequent, the better. Overall, the indices are efficient, as they give the picture of the top companies in a market at any given point in time. When you invest in an index, you simply bypass the problem of stock selection and the problem of a particular stock going out of business or turning out to be a loss making stock. The efficient index will someday or the other kick out the bad stock from it, and replace it with a better stock. The market usually perceives these changes as positive, as new better company is used to replace the old bad company, and the index value rises slightly with every change announced by the exchange.

Can I buy 30 different individual stocks listed in BSE? Will that be efficient?

As far as buying is concerned, yes you can do that. But that is not efficient. The reason is that you will have to pay big amount of brokerage to buy the 30 different stocks. Your demat account charges will also increase with more nos. of stock holdings. Secondly, when a particular stock is included in index, it is taken as a positive sign, and price rises immediately. When a particular stock is kicked out of Sensex, it is taken as a negative sign, the price falls sharply. So, by the time news reaches you and you act on that, you will end up buying a high price stock, and at the time of selling, you will have to sell it at a lower price. Can you hold it for a long period instead of selling it? Yes, but then what is the guarantee that it will give you good returns? Remember Mukund Iron, Peico, Premier Auto, discussed above. No guarantee for anything.

On the other hand, when you buy the index or an index fund, you simply buy it as 1 single stock, instead of 30 stocks or 50 stocks. You pay brokerage only on 1 particular trade and hold only 1 particular stock in your demat account. Hence, it cuts severely on the brokerage and demat charges. At the same time, it benefits you with diversification.

So is it that index or index fund investment is always efficient?

Well, not necessarily, and not always. It depends upon your investment style. There are risks associated with index investments as well. If it had been a fool-proof investment strategy, everyone would invest only in index and not other instruments. However, it is far far better than the individual stock trading backed by error-prone stock picking.

Also, Index investments are also prone to the market risks. Let’s discuss the risks associated with the index investment and the available index investment options in India in a following article.