Searches on Google for Nifty 50, Nifty 100, Nifty Midcap, Nifty Smallcap, Bank Nifty etc. are increasing every year as the concept of Index and the use of these indices as benchmarking mutual fund & portfolio performance increases. In the article below, we shall understand the finer aspects of these indices, what makes one different from the other, how they can effectively used to diversify your portfolio and how Indexes can help you identify opportunities in the stock market.
What is a Financial Index?
A Financial Index is a single measure that is used to give information about price movements of a combination of financial, commodity or related markets. The Index helps aggregate the performance of individual homogenous units into a unified, consolidated measure which can be used to understand the general state of affairs of that particular group of financial products and can be used to benchmark the performance of individual constituents against it.
Why is an Index created?
Think of it this way. If one were to ask you “by how much have the price of vegetables gone up in your city?” There is no easy way of answer that because you have been consuming a number of different vegetables and the inflation on each vegetable differs from one another. Secondly, your habits are very different from your neighbour to the millions of others who share your city as their place of residence. This is where an Index comes in and creates a bucket of vegetables on the basis of what the city is consuming.
Let’s understand this with an example in the table below.
Measuring Performance Over 2 Years
We see that some vegetables have gone down in price (potatoes are down 5% this year) while other vegetables (like peas) have gone up as high as 50%. Since it would be incorrect to say that vegetable prices have gone up or prices have gone down, we collate all information with the city’s consumption data to see that the city has spent ₹2.408 crores this year as compared to ₹2.242 crores last year. This shows a growth of 7.4% which is the “weighted” inflation in vegetables for one year.
The above calculation is weighted to the extent that items (like tomatoes or potatoes) which are more consumed by the city’s residents has a higher proportion or consideration in the calculation of the final growth rate.
Importance of an Index when Measuring Performance Over Multiple Years
An Index is a really powerful gauge when values are to be measured over multiple years. To equip this, we need to fix one point in time which is referred to as the “base year”. Effectively, this is the starting point of measurement which can be in the present or in the past.
Let’s visit this with our vegetable index. Now, we had looked at the vegetable prices in year 2016 and 2017. If the base year were taken as 2016, the number of ₹2.242 crores will be converted into the base value. Since base value needs to be a rounded clean number, we designate the base value as 100. So, ₹2.242 crores is 100. As a consequence, ₹2.408 crores is the future value of 2017 which is ₹2.408 divided by ₹2.242 multiplied by 100 — which comes to 107.4. Therefore –
- Base value (2016) = 100
- 2017 value of Index = 107.4
We mentioned earlier that the starting point of measurement can be in the past aswell. This can be done by simply doing a back calculation in the past of how the index would have shaped. An example of this is the NIFTY Smallcap 100 Index which was launched in March 2011. However the base date was kept as 01 January 2004 and the base value at 1000. The value of the NIFTY Smallcap 100 Index on the date of its launch (i.e. March 30, 2011) was 3584.16 (and not 1000).
Importance of Stock Market Indexes
- Stock market indices serve as the primary economic indicator and a strong guide to state the performance of the economy or particular sector. E.g. since the NIFTY 50 Index has 66% of the market capitalization of all companies listed on the stock exchanges in India, it forms a strong proxy to how the overall economy is doing. If the NIFTY 50 is growing by 10% over the last 5 years, it will be generally the case where the economy is growing at around the same number over the same time period.
- Stock market indices provide a historical comparison of performance which can be used to compare against other instruments like real estate, gold, commodities etc.
- These indices are often used as a benchmark against which mutual funds are compared. E.g. large cap funds often use the NIFTY 50 Index as their performance benchmark
- Indices aid in the development of a number of financial products such as Index Funds, Index Futures, Index Options etc. Infact, the NIFTY 50 Index is the largest financial product in India which includes exchange-traded funds (onshore and offshore), exchange-traded futures and options and OTC derivatives (mostly offshore). The NIFTY 50 is the world’s most actively traded contract.
Index Composition Changes Periodically
Index Maintenance is a very important activity which involves the addition and deletion of companies from an Index. This is done to ensure the stability of the Index and for confirming with the rules surrounding the creation of the Index. The National Stock Exchange (NSE) appoints an Index Policy Committee for equity and another one for debt indices. Example – the NIFTY 50 Index stocks are reviewed twice an year with the data available on 31st January and on 31st July.
Types of Indexes
There are 5 types of Indices which have been developed by the NSE Indices Limited which is a subsidiary of the National Stock Exchange of India Limited. These are –
- Broad Market Indices
- Sectoral Indices
- Thematic Indices
- Strategy Indices
- Fixed Income Indices
Let’s look at each of them in more details –
1. Broad Market Index
Broad Market Indices refer to indexes created from a large universe of stocks that are aimed at building general economic indicators. The predominant factors used in these broad market indexes are the market capitalization of the underlying securities (like large cap, mid cap & small cap) and the count of securities (50 stocks, 100 stocks, 500 stocks etc.)
NSE has a total of 12 broad market indexes which are the NIFTY 50, NIFTY Next 50, NIFTY 100, NIFTY 200, NIFTY 500, NIFTY Midcap 150, NIFTY Midcap 50, NIFTY Midcap 100, NIFTY Smallcap 250, NIFTY Smallcap 50, NIFTY Smallcap 100 and NIFTY MidSmallcap 400
Let’s look at each of them in greater details
One of the terms you would have seen in the table above is “Free Float Market Capitalization”. Free float refers to that portion of a company’s outstanding shares that are held by the general public and not by less-liquid stakeholders like government, royalty or company insiders. Learn a lot more about free float market capitalization by clicking on this article link
Notice the predominance of the Financial Services sector in most of the indexes barring two – NIFTY Next 50 and Nifty Smallcap 100. We recently saw in a blog post on Nifty 50 stocks that the financial services stocks dominate the Nifty 50 with a market capitalization of over 37%. This changes in case of NIFTY Next 50 because there are a lower number of financial services companies which are ranked between 51 and 100 in the market capitalization list. Unlike 37% in the case of NIFTY 50, financial services share of the Index is only 20% in the case of NIFTY Next 50.
2. Sectoral Index
The sectoral indices benchmark the performance of stocks from a particular sector. These sectoral indices help investors and mutual fund managers address their requirements of portfolio revision and diversification. The sectoral index available on the NSE are – NIFTY Auto, NIFTY Bank, NIFTY Financial Services, NIFTY FMCG, NIFTY IT, NIFTY Media, NIFTY Metal, NIFTY Pharma, NIFTY Private Bank, NIFTY PSU Bank and NIFTY Realty
Let’s detail these out a bit more
We mentioned diversification earlier. In addition to just spreading out the stocks across sectors, using sectoral indices within reason, can lift your returns with a much lower proportionate risk. For example – The Nifty 50 is operating at a PE ratio of 28.44 (May 2019) with a 38% share of the Index in financial services stocks. The Bank Nifty itself is at a PE of 60.95 which means bank stocks are extremely expensive (see the list of index highs and lows below).
This financial services sector concentration puts your portfolio at risk as a drop in the fortunes of banks can harm your returns significant. On the other hand, let’s look at the Nifty Auto which currently operates at a PE of 22.09 (May 2019). Investing in the Nifty Auto can provide much needed diversification to your portfolio in addition to lowering your risk. Further the fact that you are getting auto stocks cheap, this increases your scope of making above-average gains when auto stocks come back in favour.
Learn more about this important topic in a comprehensive article on improving portfolio returns while reducing portfolio risk we had written in a previous article on this blog.
5-Year Performance of Various Nifty Index
Sectoral stocks (and indices) are more cyclical in nature as compared to broad market indices. This is evident from the Price-Earning ratio (PE ratio) data below where the swings (i.e. the difference in the 5-year highs and 5-year lows) are much bigger in sectoral indices (except Nifty FMCG & Nifty IT) as compared to the broader indices.
The above table reveals that some sectors like Auto, Media and Metals are currently valued at much below their 5-year P/E average trend while other sectors like Bank, Financial Services and even a broader index like Nifty Next 50 are far ahead of their 5-year P/E average.
As an investor you can use the above data to take calls on how to diversify and rebalance your portfolio so that you improve your chances of a higher returns or a lower loss.
What do fund managers say about placing caps (limits) on sector weights in indices?
This article was published earlier this week on livemint (article: Does it make sense to place caps on sector weights in indices?). The basis of this argument is the high share of banking and finance sector to the Nifty 50 Index where this one sector has a 38% allocation to the index’s fortunes. I liked the perspectives of different fund managers & am presenting a summary of what they are saying –
- Nilesh Shah (Chief Executive Officer of Kotak Mahindra Asset Management) prefers to stay with the global trends where most indices don’t have a sectoral cap. As a result, the Kospi (Korea) have a tilt towards tech while Brazil & Russia are skewed on commodities. He also contends that the capping will curb the performance of better performing sectors in favour of non-performing sectors.
- Aashish P. Somaiyaa (Managing Director & CEO at Motilal Oswal Asset Management) also finds sectoral capping being against free market principles and by capping, we will not be reflecting the current economic composition (or instead manipulating the view).
- Koel Ghosh (Head of Business, APAC at S&P Dow Jones) says that the introduction of sector cap requirements especially on broad market indices will impact products linked to those indices. (this is true; imagine comparing a large cap fund with a benchmark like Nifty 50 which is not a true benchmark because of the limitations). The lack of quality indices does harm to the capital markets as it potentially leads to loss of access to investor capital
- Kalpesh Ashar (Proprietor at Full Circle Financial Planners and Advisors) feels that capping sectors like bring more stability and diversification.
3. Thematic Index
What is the difference between a sector and thematic fund?
This is a common question posed by investors. The difference between a sector and thematic fund is similar to your style of diet plan. You might say, “I will eat only vegetables this week” (sector) or you might say, “I will eat foods that are less than 300 calories” (thematic).
A sectoral index or fund, as we saw in the previous section, aims at investing in specific sectors of the economy like auto, banks, media, metals, information technology, pharma etc. These businesses are cyclical in nature and it’s almost always the case that at a given point, some sectors are really hitting the roof while other sectors are sagging much below their earlier highs. Sectoral funds are suitable for investors who are looking at building long-term capital growth and can take high risks.
Thematic funds invest in particular themes and are not bound by the sector. This means thematic indices are broader than sectoral indices and offer greater diversification to investors. For example – NIFTY India Consumption Index comprises companies from sectors ranging from Healthcare, Telecom, Auto, Hotels, Media, Pharmaceuticals and others. Notice that this theme (India Consumption) has some sectors where sectoral index are also available, namely auto, media and pharma.
A key differences between thematic and sectoral indices from an investor perspective are the number of participating stocks. The stocks in thematic index (or mutual funds) are often higher than the sectoral index. While 12 stocks is the median for sectoral indices, the thematic indices operate at a median of 20 stocks. This diversification helps investors in terms of improved down-side protection as the risk is spread across multiple companies and multiple sectors. However I have observed that the returns (or losses) from thematic indices may not be as dramatic as sectoral indices
Types of Thematic Indices
There are 16 different thematic index on offer which can be broken down as (these are my terminologies, not official terms) –
- Industrialist Themes
- NIFTY Aditya Birla Group
- NIFTY Mahindra Group
- NIFTY Tata Group
- NIFTY Tata Group 25% Cap
- India Shining Themes
- NIFTY Commodities
- NIFTY CPSE
- NIFTY Energy
- NIFTY India Consumption
- NIFTY Infrastructure
- NIFTY MNC
- NIFTY PSE
- NIFTY Services Sector
- Stock Market Bubbling Themes
- NIFTY100 Liquid 15
- NIFTY Midcap Liquid 15
- Religious Themes
- NIFTY50 Shariah
- NIFTY Shariah 25
- NIFTY500 Shariah
Let’s look at each of them in greater details.
A Closer Examination of Capping Sectors or Proportion of Stock in an Index
Earlier in this blog post, we saw some for and against arguments from experts on whether there should be capping in indices. The examination was on the pros and cons of that where the fund managers often looked beyond the investor picture on other variables like growth of capital markets, global benchmarks etc. which might not be exactly what investors like you and I will be worried about. So, lets investigate the above argument in terms of whether capping leads to better returns or lower risk.
Our investigation lands us on a comparison between two indices – one which has a capping and the other which doesn’t have a capping.
- Nifty 100 Index
- Nifty 100 Equal Weight Index
The Nifty 100 does not have any capping while the Nifty 100 Equal Weight Index has a capping where all constituents (companies) are allocated a fixed equal weight at each re-balancing. To see if capping or no-capping makes a difference in the returns, we populated the performance of the Nifty 100 Index and the Nifty 100 Equal Weight Index using a common base of 100 from August 2013 until May 2019 – a period of almost 6 years.
We see that on an overall basis, the Nifty 100 Equal Weight Index performed better than the Nifty 100 Index most of the time. However, in the last two months (April & May), the Nifty 100 Index piped the Nifty 100 Equal Weight Index. The plausible reason for the same is the sudden growth in large cap funds over the last 2 months (from the 2nd half of March 2019 onwards).
Overall, the Nifty 100 Equal Weight has seen better times when the midcaps were doing well because this Index gives an equal weight to the beyond top 50 companies (ranked 51 to 100) as opposed to the Nifty 100 Index which gives a much lower weight to the 51 to 100 ranked companies. The same trend has recently reversed as the heavily loaded large caps in the Nifty 100 have been doing well which has seen them perform better than the Equal Weight Index. The above can be seen on an year on year basis as shown in the data below.
- Aug 2013 to Jul 2014 : 43% (Nifty 100), 55% (Equal Weight)
- Aug 2014 to Jul 2015 : 10% (Nifty 100), 11% (Equal Weight)
- Aug 2015 to Jul 2016 : 9% (Nifty 100), 12% (Equal Weight)
- Aug 2016 to Jul 2017 : 16% (Nifty 100), 15% (Equal Weight)
- Aug 2017 to Jul 2018 : 13% (Nifty 100), 5% (Equal Weight)
- Aug 2018 to May 2019 : -4% (Nifty 100), -12% (Equal Weight)
4. Strategy Index
We have seen the use of specific sectors and specific concepts (thematic). We now move to the Strategy Indices.
Difference between Thematic and Strategy Index?
- While the thematic indices are based on concepts like MNC (multinational companies), PSE (public sector enterprises) etc., the strategy indices are based on ideas. The ideas here refer to the use of certain techniques (read: strategies) which can dip into the entire universe of companies and pull out certain companies that fit the idea. For example – the investor wants to have those companies in the portfolio which have the highest dividend yield or the lowest volatility or highest liquidity etc. These ideas are not necessarily factored in the case of thematic index selection.
- The thematic indices have access to a much lower universe of companies as compared to strategy indices. We see that the average number of stocks in the thematic indices is around 20. In the case of most strategy index, the average number of stocks in around 50.
- Until now, we have been seeing only equity participation in the broad market, sectoral and thematic indices. This is where the strategy index is different because it makes use of different assets like derivatives, debt, arbitrage, liquidity and also leverage in the development of different strategies. As a consequence, the returns and the risk expectations of different strategies is varied. Additionally, strategy index can be a combination of different assets aswell.
- Strategy index based on just equity include the NIFTY100 Equal Weight, NIFTY100 Low Volatility 30, NIFTY Alpha 50, NIFTY Dividend Opportunities 50, NIFTY High Beta 50, NIFTY Low Volatility 50, NIFTY50 Dividend Points, NIFTY100 Quality 30, NIFTY50 Value20, NIFTY Growth Sectors 15, NIFTY50 PR 1x Inverse and NIFTY50 TR 1x Inverse
- Strategy index based on derivatives include NIFTY 50 Futures and NIFTY 50 Futures TR
- Strategy index based on arbitrage and debt elements is the NIFTY 50 Arbitrage
- Strategy index based on leverage include NIFTY50 PR 2x Leverage and NIFTY50 TR 2x Leverage
Let’s look at the various strategy index in greater details.
5. Fixed Income Index
The Fixed Income indices are suited for investors who are risk-averse and are seeking investment avenues which offers solid down-side protection albeit at the expense of superlative returns.
The various fixed income indices available on the NSE are NIFTY 8-13 yr G-Sec, NIFTY 10 yr Benchmark G-Sec, NIFTY 10 yr Benchmark G-Sec (Clean Price), NIFTY 4-8 yr G-Sec, NIFTY 11-15 yr G-Sec, NIFTY 15 yr and above G-Sec, NIFTY Composite G-Sec and NIFTY 1D Rate Index
Let’s look at these in greater details