Searches on Google.com for Nifty 50, Nifty 100, Nifty Midcap, Nifty Smallcap, Bank Nifty etc. are increasing every year. This shows greater consumer interest as the concept of Index and it’s use as a benchmarking tool increases. In this post, we shall understand the finer aspects of these indices and what makes one different from the other. We also learn how different index funds can diversify your portfolio, identify opportunities & improve your risk rated returns.
What is a Financial Index?
A Financial Index is a single measure that is used to give information about price movements. This information can be for financial, commodity, currency or related markets.
In other words, the Index aggregates the performance of individual homogenous units into a unified, consolidated measure.
This measure is used to understand the general state of affairs of that particular group of financial products. Additionally, it is 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 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 or to the millions of others who share your city. The vegetable index includes not only yours but their consumption too as it is their place of residence aswell. This is where an Index comes in. The index 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 here that some vegetables have gone down in price like potatoes which are down 5% this year. And we see that other vegetables (like peas) have gone up as high as 50%.
Thus, it is incorrect to say that vegetable prices have gone up or prices have gone down. As a process, we collate all information with the city’s consumption data to have a better assessment.
We 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.
How are Index developed over multiple years?
An Index is a really powerful gauge when values are to be measured over multiple years.
To equip this, we 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 understand 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 value of 2017.
Next it’s ₹2.408 divided by ₹2.242 multiplied by 100 — this 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 is done by simply doing a back calculation in the past of how the index would have shaped.
An example is the NIFTY Smallcap 100 Index. This index was launched in March 2011.
However the base date was kept as 01 January 2004 and the base value at 1000. So, 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 Index
- Stock market indices serve as the primary economic indicator. They are a strong guide to state the performance of the economy or particular sector.
- Stock market indices provide a historical comparison of performance. This allows comparison against other instruments like real estate, gold, commodities etc.
- These indices serve as benchmarks 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. This 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.
Elaborating point 1 above, the NIFTY 50 Index has 66% of the market capitalization of all listed companies. This measure forms a strong proxy to how the overall economy is doing (atleast from a stock market perspective). If the NIFTY 50 is growing by 10% over the last 10 years, you are likely to see that the economy (GDP) too is growing by 10% over the decade.
Further, there is no doubt that index mutual funds in India and the world are on an uptrend. The United States is leading the index fund brigade and it is a matter of time when Indian investors recognise strategies with index funds.
Recommended Books on Stocks Markets & Investing
Index Composition Changes Periodically
Index Maintenance is a very important activity which involves the addition and deletion of companies from an Index. This ensures the stability of the Index and confirmity with the index creation rules.
The National Stock Exchange (NSE) appoints an Index Policy Committee for equity and another one for debt indices. For example – the NIFTY 50 Index stocks are reviewed twice an year. The data used is what is available for analysis on 31st January and on 31st July of the year.
Recommended Article : $4 Trillion & Rising – The Index Funds Story in 2020
Types of Indexes
- Broad Market Indices
- Sectoral Indices
- Thematic Indices
- Strategy Indices
- Fixed Income Indices
Let’s look at each of them in more details –
Broad Market Index
Broad Market Indices refer to indexes created from a large universe of stocks aimed at building general economic indicators.
Dominant factors used in broad market indexes are the market capitalization of the underlying securities and the count of securities. Market capitalization will be in the form of large cap, mid cap & small cap. And count of securities will be 50 stocks, 100 stocks, 500 stocks etc.
NSE has a total of 12 broad market indexes. These 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 is held by the general public. Free float excludes shares held by less-liquid stakeholders like government, royalty or company insiders.
Also notice the predominance of the Financial Services sector in most of the indexes.
Except two – NIFTY Next 50 and Nifty Smallcap 100.
Let’s see what’s the difference here.
Nifty 50 is dominated by financial services stocks who have a market capitalization of over 37%. However in Nifty Next 50, financial services share of the Index is only 20%.
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.
Sectoral indices 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 risk-adjusted returns.
Let’s understand this using the PE Ratio as an anchor
The Nifty 50 PE Ratio is 28.44 as on May 2019. We know that the NIfty 50 has a 38% share in financial services stocks.
Now, we see that the Bank Nifty Index is at a PE of 60.95 which means bank stock PE are pushing up the broader index.
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. You are also getting auto stocks on the cheap. This increases your chances of making above-average gains when auto stocks come back in favour.
Learn more about the risk & return interplay in a comprehensive article on improving portfolio returns while reducing portfolio risk I had written earlier 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. We see this from the Price-Earning ratio (PE ratio) data below. Sectoral indices has much higher swings as compared to broader indices. The only exception to this are the Nifty FMCG & Nifty IT index.
The above table reveals some opportunities. Sectors like Auto, Media and Metals are currently valued at much below their 5-year P/E average. Other sectors like Bank, Financial Services and even the Nifty Next 50 is 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. This is likely to improve your chances of a higher returns or a lower loss.
What fund managers say about placing caps (limits) on sector weights in indices?
Livemint publish an article on this subject. 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) is tilted 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. He say that capping will not be reflective of 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. I agree because capping financial services to say, 20% will not be reflective of a large cap fund’s bencmark i.e. Nifty 50. The lack of quality indices does harm the capital markets as it 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.
What is the difference between a sector and thematic fund?
This is a common question from 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 aims at investing in specific sectors of the economy. These include sectors like auto, banks, media, metals, information technology, pharma etc. These businesses are cyclical in nature. Almost always the case, at a given point, some sectors are 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. They 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.
Diversification helps investors with improved down-side protection as 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
Recommended Books on Stocks Markets & Investing
Types of Thematic Indices
There are 16 different thematic index on offer. These 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, we saw some for and against arguments from experts on whether there should be capping in indices.
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 of these have a capping and the other 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. The Nifty 100 Equal Weight Index 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 their performance. For the Nifty 100 Index and the Nifty 100 Equal Weight Index, I used common base of 100. The examination period was 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 this is the sudden growth in large cap funds over the last 2 months.
Overall, the Nifty 100 Equal Weight has seen better times when the midcaps were doing well. This is because this index gives an equal weight to the beyond top 50 companies (ranked 51 to 100) while 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.
Here is how the annual performance stacks up.
- 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)
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.
- Example of a strategy index. The investor wants to include companies in the portfolio with the highest dividend yield. Or it can be lowest volatility or highest liquidity etc.
- 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. 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 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
- Arbitrage and debt elements strategy index 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.
Fixed Income Index
Fixed Income indices is useful for investors who are risk-averse. They are the one seeking investment avenues which offers solid down-side protection even 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
- Clean Price NIFTY 10 yr Benchmark G-Sec
- NIFTY 4-8 yr G-Sec
- NIFTY 11-15 yr G-Sec
- Longer term NIFTY 15 yr and above G-Sec
- NIFTY Composite G-Sec and
- NIFTY 1D Rate Index
Let’s look at these in greater details
Here are some articles you can read to get better details on financial and stock metrics
- Rakesh Jhunjhunwala and his secrets to investing (Part 1)
- Building a high return portfolio with index funds – a step-by-step approach
- Complete SIP Investment Guide (over 8000 words compedium updated until 2020)
- The trillion dollar index fund story that John Bogle started in the 1970s
- Best SIP for achieving long term goals