Stock Market for Dummies: Basics of Index
We all at some point of time in our lives have heard how the markets rose today by so and so points and they constantly keep on throwing this term around, ‘NIFTY’ interchangeably. There are some obvious questions that might pop up in your mind like
What is NIFTY?
Aren’t market and NIFTY the same thing?
What are the uses of NIFTY and can I invest in it?
All these are valid questions that I wish to answer via this article.
What is NIFTY?
Launched on April 1, 1996, NSE’s NIFTY stands for National Index Fifty and is one of the two main stock indices used in India (other being BSE’s SENSEX).
There are total 1795 companies listed on the National Stock Exchange of India (NSE) as on March 31, 2020.
Now tracking these 1795 companies is practically impossible, so a subset of 50 shares is taken as a representation of the entire population of these companies and is used as an indicator of the performance of the Indian capital market as a whole.
From now if anyone says ‘NIFTY is up by 3% today’ it means only those 50 shares put together are up by 3% and not all the 1795 shares.
Composition of NIFTY
NIFTY comprises of 50 shares selected from 14 major sectors. This index tracks the behavior of a portfolio of blue chip (highly reliable and have withstood the test of time) companies, the largest and most liquid Indian securities and captures approximately 65% of (float-adjusted) market capitalization. That is, these shares are approximately 65% in value of the total freely available for trade shares.
These 50 shares are selected based on this methodology.
The index is reconstituted semi-annually considering 6 months data ending January and July respectively. The replacement of stocks in NIFTY 50 (if any) is generally implemented from the first working day after Futures & Option (F&O) expiry of March and September.
The expiry of F&O contracts is on the last Thursday of the month, so the stocks are effectively replaced on the last Friday or the next working day if Friday happens to be a holiday.
If you don’t want to be bothered with all the mumbo-jumbo, you can just check the reconstitution calendar here.
So based on the above linked methodology and the calendar, one can prepare a tentative list of shares that might get added and removed and be better positioned as any addition to the index is received positively and vice-versa.
Uses of NIFTY
It is used for a variety of purposes, such as benchmarking fund portfolios, index based derivatives and index funds.
Many investment products based on NIFTY indices have been developed within India and abroad. These include index based derivatives traded on NSE, NSE IFSC and Singapore Exchange Ltd. (SGX) and a number of index funds and exchange traded funds.
Most mutual funds managers use NIFTY50 as a yardstick for the performance of their fund. A fund is said to be ‘good’ if it is able to beat NIFTY50.
But NIFTY50 isn’t the only benchmark index, for eg. NIFTY BANK will be a much better benchmark to measure the performance of a banking centric mutual fund than NIFTY50.
What is NIFTY50 TRI?
TRI is basically an index which will track both the capital gains of a scheme and assumes that any cash distribution, such as dividends, are reinvested back into the index.
Dividend in an index is somewhere around 1.8% annually. The vanilla NIFTY index excludes the dividend returns and thus is understated by the same.
From February 1, 2018 mutual funds are mandated by Securities and Exchange Board of India (SEBI) to use the NIFTY50TRI to benchmark their performance and not the vanilla index.
For eg: If you have invested in a Growth Fund A (which reinvests any dividend income earned from the shares held back in the fund) and is currently outperforming the NIFTY50 by 2 per cent.
The above comparison would be incorrect as NIFTY50 doesn’t account for any dividend income reinvested. The correct way is to measure the performance of the fund against NIFTY50 TRI which adjusts NIFTY50’s performance for any dividend income reinvested and thereby giving a much more realistic picture, i.e. an actual out performance of mere 0.2 per cent.
Make sure that while reporting their earnings, mutual fund houses use NIFTY50 TRI (Total Return Index) and not NIFTY50!
Investing in NIFTY
Given that NIFTY tracks the performance of the top 50 listed companies in India, one would want to invest in these companies.
If you look at the above table, the index has given a compounded annual growth rate (CAGR) of 10.23% which is way attractive than any risk free instrument such as fixed deposits which are taxed at your slab rate versus the returns from investing in ‘market’ are categorized as capital gains and are liable to special and more relaxed tax rates (this a whole another can of worms which I’ll take up in the upcoming articles).
Long term investors looking for exposure to the index can invest in index mutual funds whereas a short term investor or intraday trader can invest in exchange traded funds (ETFs) which are highly liquid and mirror the performance of the index.
The major incentive of an index fund is the low expense ratio, where an average mutual fund will have an expense ratio of anywhere from 0.3 per cent to up-to 2.5 per cent, you can easily find index funds with the expense ratio of 0.1 per cent (the cheapest one I came across was one with 0.05 per cent expense ratio!). A fund with lower expense ratio will not chip away your gains as much as one with a higher ratio would.
The importance of investing in index fund can’t be emphasized which bring to mind a very famous bet between Warren Buffet and a hedge fund manager Ted Seides. The whole story can be read here, which I would recommend everyone goes through once.
The gist being, Warren Buffet had challenged the hedge fund industry to bet their own money, where he would invest in a low cost index fund and the fund manager would invest in hedge fund of their choice for a time horizon of 10 years from 2008 to 2017. The proceeds from the bet would go to the charity of the victor’s choice. To no one’s surprise, the index fund outperformed the hedge fund and Ted Seides had conceded defeat an year ahead of the deadline.
Conclusion
No matter what the investment horizon or risk appetite one has, index fund should form a part of all passive investors’ portfolio.
We’ve barely begun to scratch the surface with all the above information on index and there’s still a lot more that there is to it and it’s associated products. I hope to plan on addressing most of it, if not all in the upcoming articles.
Note: BSE’s SENSEX which is second most referred index in India and the oldest in Asia, has not been talked about in this article intentionally due to lower trading volumes and therefore lower turnover and liquidity.
