STOCK INDEX
A stock market index should capture the behaviour of the overall equity
market. Movements of the index should represent the returns obtained by
"typical" portfolios in the country.
They reflect the changing expectations of the stock market
about future dividends of India's corporate sector. When the index goes up, it
is because the stock market thinks that the prospective dividends in the
future will be better than previously thought. When prospects of dividends in
the future become pessimistic, the index drops. The ideal index gives us
instant-to-instant readings about how the stock market perceives the future of
India's corporate sector.
Every stock price moves for two possible reasons: news about
the company (e.g. a product launch, or the closure of a factory, etc.) or news
about the country (e.g. nuclear bombs, or a budget announcement, etc.). The
job of an index is to purely capture the second part, the movements of the
stock market as a whole (i.e. news about the country). This is achieved by
averaging. Each stock contains a mixture of these two elements - stock news
and index news. When we take an average of returns on many stocks, the
individual stock news tends to cancel out. On any one day, there would be good
stock-specific news for a few companies and bad stock-specific news for
others. In a good index, these will cancel out, and the only thing left will
be news that is common to all stocks. The news that is common to all stocks is
news about India. That is what the index will capture.
For technical reasons, it turns out that the correct
method of averaging is to take a weighted average, and give each stock a
weight proportional to its market capitalisation. 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 we attach a weight of 1/4 to
movements in A and 3/4 to movements in B.
It is easy to create a portfolio, which will reliably get the
same returns as the index. i.e. if the index goes up by 4%, this portfolio
will also go up by 4%. Suppose an index is made of two stocks, one with a
market cap of Rs.1000 crore and another with a market cap of Rs.3000 crore.
Then the index portfolio will assign a weight of 25% to the first and 75%
weight to the second. If we form a portfolio of the two stocks, with a weight
of 25% on the first and 75% on the second, then the portfolio returns will
equal the index returns. So if you want to buy Rs.1 lakh of this two-stock
index, you would buy Rs.25,000 of the first and Rs.75,000 of the second; this
portfolio would exactly mimic the two-stock index. A stock market index is
hence just like other price indices in showing what is happening on the
overall indices -- the wholesale price index is a comparable example. In
addition, the stock market index is attainable as a portfolio.
Traditionally, indices have been used as information sources.
By looking at an index we know how the market is faring. This information
aspect also figures in myriad applications of stock market indices in economic
research. This is particularly valuable when an index reflects highly uptodate
information (a central issue which is discussed in detail ahead) and the
portfolio of an investor contains illiquid securities - in this case, the
index is a lead indicator of how the overall portfolio will fare. In recent
years, indices have come to the fore owing to direct applications in finance,
in the form of index funds and index derivatives. Index funds are funds which
passively `invest in the index'. Index derivatives allow people to cheaply
alter their risk exposure to an index (this is called hedging) and to
implement forecasts about index movements (this is called speculation).
Hedging using index derivatives has become a central part of risk management
in the modern economy. These applications are now a multi-trillion dollar
industry worldwide, and they are critically linked up to market indices.
Finally, indices serve as a benchmark for measuring the performance of fund
managers. An all-equity fund should obtain returns like the overall stock
market index. A 50:50 debt:equity fund should obtain returns close to those
obtained by an investment of 50% in the index and 50% in fixed income. A
well-specified relationship between an investor and a fund manager should
explicitly define the benchmark against which the fund manager will be
compared, and in what fashion.
The most important type of market index is the broad-market index, consisting
of the large, liquid stocks of the country. In most countries, a single major
index dominates benchmarking, index funds, index derivatives and research
applications. In addition, more specialised indices often find interesting
applications. In India, we have seen situations where a dedicated industry
fund uses an industry index as a benchmark. In India, where clear categories
of ownership groups exist, it becomes interesting to examine the performance
of classes of companies sorted by ownership group.
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