ETF Indexing Chapter2

After dinner, Shivkumar was unwinding over a cup of filter coffee. Mini had

put Aditya to bed and she joined him, chatting happily about everything

that happened during the day. As was the case lately, the topic soon came

around to the little baby they were expecting. It was then that Shiv remembered

his conversation with his colleagues on the way home. He told Mini about it and

she listened with attention. When he explained how he wished he could invest

in the index, she smiled sweetly and said, “What exactly is an index? I know that

the Sensex and the Nifty are indices but how is an index created? Why does its

value keep changing? How does one index differ from another? And…” “Hold it;

hold it…” he replied, smiling back at her affectionately. “One question at a

time” Although he was now a professional copy writer, he had graduated in

statistics and was very conversant with how indices were created and how they

worked.

SECTION 2

Back To Basics

Back To Basics

19

Back To BasicsETFs AND INDEXING

20 21

“Let me explain what an index is with the help of an analogy that you would

understand,” he began. “Now I know that you are an expert at managing the

household budget, so why don't we create an example around that.” She

looked at him quizzically but let him carry on. “Let's decide what broad

categories our household expenses fall under. What would these be?” After

thinking a little, she replied, “Groceries, toiletries, vegetables, milk, fees, utility

and other bills and loan repayments, salaries to domestic help and other

miscellaneous expenses like toys and clothes, eating out, minor household

repairs, etc.”

“Alright,” nodded Shiv. “Now, let's say we

begin our indexing exercise with last

month's house hold expenses as the

base. This means from now on, we will

compare all rises in the budget to last

month's level of expenses.”

“Would you be able to tell me how much

was spent on each broad head?” he

asked. “That would be difficult,” she answered, frowning a little. Shiv carried

on, “Just for simplicity sake, shall we assume that Rs 17,000 went towards

payment of fees, bills and loan repayments, another Rs 8,000 towards

groceries, toiletries, vegetables and milk, yet another Rs 5,000 towards

salaries of domestic helpers and Rs 4,000 towards miscellaneous expenses?”

“Sounds fair enough,” she replied. “When we total up all these expenses, we

realise that we spent a

total of Rs 34,000. To

make this figure our

base, we reduce it to

100.”

Then he jotted it down on

a handy note book to

make it clearer for her. “Now suppose this month, for some reason, the amount

that is spent on each sub head increases by 10 per cent, i.e., fees, bills and

loan repayments become Rs 18,700, groceries et al become 8,800, salaries

increase to Rs 5,500 and miscellaneous expenses become Rs 4,400. The

index will increase by 10 per cent.”

Again, he jotted down and she was impressed to see that an increase of 10 per

cent in each item took the index so neatly to 110. He then explained that as the

value of the components of the index increased or decreased, the overall index

would increase or decrease accordingly. “What if some components increase

and others decrease?” she asked. “Then the index would increase or decrease

depending on whether the magnitude of the increase or decrease was

greater,” he explained. Alongside, he drew out a couple of further extensions

on the same index base. He showed her how a 10 per cent decrease in all the

items would result in a decrease of 10 per cent in the overall index. Then how a

mix of increasing and decreasing items could either result in an increase or

decrease in the index.

Finally, Mini said, “I understand how that basic index works but does it work in

the same way for stocks?” “Yes, the construction of a stock market index works

on a similar principle,” explained Shiv. “A stock market index is created by

Bills, fees and loans

Groceries etc

Salaries

Misc.

Total

Index calculation

8,000

5,000

4,000

34,000

Base Month

17,000

34,000

34,000x100.00

Index number 100.00

Bills, fees and loans

Groceries etc

Salaries

Misc.

Total

Index calculation

Index number

Base Month

17,000

8,000

5,000

4,000

34,000

34,000

34,000x100

100.00

18,700

8,800

5,500

4,400

37,400

110.00

37,400

34,000x100

Month 2

Bills,

fees and

loans

Groceries

etc

Salaries

Misc.

Total

Index

calculation

Index

number

17,000

8,000

5,000

4,000

34,000

34,000

= 100.00

Base

Month

37,400

34,000x100

18,700

8,800

5,500

4,400

37,400

= 110.00

Month 2

30,600

34,000x100

15,300

7,200

4,500

3,600

30,600

= 90.00

Month 3

33,700

34,000x100

16,500

8,200

5,100

3,900

33,700

= 99.11

Month 4

18,200

8,300

4,800

3,900

35,200

= 104.00

35,200

34,000x100

Month 5


22 23

putting together, with the help of a formula, the values of stocks of certain

select companies traded in a particular market. Accordingly, as the values of

the component stocks fluctuate, so does the index.”

“What formula is used to calculate a stock index?” asked Mini, all charged up

with the informal tutorial in statistics that she was enjoying. “Actually, the

formula for calculating the index could differ from index to index. For instance,

there are market-value weighted indices, free float market value-weighted

What is Indexing?

Indexing to beat active investing

Indexing is the process of linking the performance of a portfolio of stocks to that of an

index. More specifically, it involves investing in a pool of stocks that form part of an index

in the same proportion as is there in the index. It is done to replicate the performance of an

underlying market, especially if the index is a broad market index, which closely matches

the return of the overall stock market.

Alternatively, indexing to a more specific index allows the investor to quantitatively track

and measure the returns that have been earned by some underlying group of securities.

It is convenient as it becomes a 'Set it - forget it' strategy, as the returns will not stray far

from that of the market.

As investment guru Peter Lynch explains, “All the time and effort people devote to picking

the right fund, the hot hand, the great manager have, in most cases, led to no advantage."

and "Most individual investors would be better off in an index mutual fund.” This is

because stock market investment is not a zero sum game, i.e., when markets are up,

everyone wins and when markets are down, every one loses, with exceptions. However,

outperforming the market is a zero sum game, i.e. for some investors to outperform the

average, others have to under-perform. In the process, mirroring an index gives an

investor the best chance to reap market linked returns.

Facets that make up an ideal index

The creation of an ideal index is the dream and hope of market researchers. An ideal index

is one that is

lRepresentative of the market

lAdaptable to the dynamics of the market

lTransparent

lServes as a suitable benchmark for portfolio managers, enabling them to

evaluate the performance of their portfolios.

Different types of indices based on their method of construction

lMarket-value weighted index

lFree float market value-weighted index

lPrice-weighted index

l Total Returns index

lEqually-weighted index

In this method, each stock selected to form the index is given a weighting that is directly

proportional to the market capitalization of that stock. This method is based on the premise

that large companies have bigger revenues and higher profits, as compared to small

companies. Thus, they have a higher impact on economic activities and should therefore be

given a higher weightage. The following stock indices are constructed using this method:

?Wilshire 5000?NYSE Composite Index?London FTSE

The market value-weighted index takes into account all the shares issued by a company.

However, normally not all the issued shares are available for trading. Some shares, like the

holdings of promoters, those held by the Government, those acquired under the FDI route, etc.

are not freely traded. Experts opine that only the shares that are freely available for trading,

also called free float shares, should be used to compute an index. Only then can the true market

trend can be comprehended. An index that follows this method is called a free float market

value-weighted index or float adjusted market value-weighted index. In India, the BSE Sensex

and a few other BSE indices follow the free float methodology. The Nasdaq Composite index is

also constructed using the free float market value weighted method

In this method, each stock is given a weight that is directly proportional to its market price. The

following indices are constructed using this method:lDow Jones Industrial Average (DJIA)lNikkei 225

A price index reflects the returns one would earn if investment is made in the index portfolio.

However, it does not take into consideration the returns arising from dividend receipts. Only

the capital gains arising due to the price movements of constituent stocks are captured by a

price index. To get a better picture of returns, the dividends received from the constituent

stocks also need to be factored into the index values. Such an index, which includes the

dividends received, is called the Total Returns Index.lTotal returns indices are available on the S&P CNX Nifty Price index and

other S&P CNX Nifty indices

In this method, as the name suggest, each stock is given an equal weight. No differences in

weighting are attached to large and small companies. Normally, in any market, there are a

large number of small companies and only a few big companies. This method attaches a lot of

importance to the activities of small companies.

?S&P CNX Nifty?CNX Nifty Junior?S&P CNX 500

“Most of the mutual fund investments I have are index funds, approximately 75%.”

- Charles R. Schwab, founder and CEO of the Charles Schwab Corporation


24 25

indices, price-weighted indices, equally-weighted indices and others too”

Mini looked a little confused and before she could spring another barrage of

questions at him, Shiv continued, “These indices are constructed by experts

and understanding how an index is constructed may be an interesting

intellectual pursuit. However, from the point of view of an investor who needs to

track the stock market, it is enough to know that it is created in a way that it

reflects the movement and trends of the market or segment of the market,

depending on the choice of stocks that go to make up the index.”

“But aren't all the stocks that are traded on the exchange included in the index

calculation?” inquired Mini, who was still using the household budget index as

a backdrop for understanding stock market indices. “Oh no. Stock indices are

generally classified as broad based indices and sector specific indices,

depending on the size and width of the market they depict.

The stocks that go to build up an index are chosen in such a way that they

represent the market or the segment of the market that they are meant to

reflect. So, for instance, a pharma index will consist of major pharma stocks

and a mid cap index will comprise of stocks of companies with a particular level

of market capitalisation. In short, an index is a benchmark against which the

investors compare and evaluate the performance of their equity portfolio or

holdings. And different indices reflect unique segments of the market”

Mini was looking a little tired now. She suddenly remembered the whole point

of the exercise. “I get the broad picture of what an index is but why would

anyone want to create an index?” Shiv, who was more keyed up than ever,

explained, “The main objective of creating an index is to gain a snapshot view

of how the market or a segment of a market is performing. It also gives

investors the opportunity to link or compare the

performance of their investments to that of the index.

This process is called indexing. For instance, if an

investor's portfolio has not performed as well as the

index, it means that if he had chosen another set of

stocks, he might have got a better return. More

broadly, indexing is the process by which the

performance of a particular market or portfolio is

linked to a representative stock index.”

Broad based indices and sector specific indices

lBroad base indices

lSector specific indices

A broad base index represents the performance of the entire stock market. For this purpose, the

index represents various key industries or sectors of the economy. Most of the popularly quoted

indices, like DJIA, S&P CNX 500, S&PCNX Nifty and BSE Sensex, are broad base indices.

A sector specific index is a specialized index that represents the performance of a specific

sector of the economy. For instance, the Morgan Stanley Biotech index represents trends in the

biotechnology industry in the US market. Similarly, the CNX BANK , the CNX Realty and the

CNX IT are other examples of sectoral indices in the domestic market.

History of indexing

When the Vanguard Group was newly formed in 1975, John Bogle first presented the idea of

indexing to the board of directors. When questioned about how he managed to convince them to

issue the first index fund, Bogle says, “"I projected the costs of managing an index fund to be 0.3

per cent per year in operating expenses and 0.2 per cent per year in transaction costs. Since

fund annual costs at that time appeared to be about 2.0 per cent, I concluded that an index fund

should reasonably be expected to provide an annual return of +1.5 per cent above managed

fund.”

Did you know…

Stock market indices have been in existence since the late nineteenth century. The Dow Jones

Average was the first index to be created. It was constructed by Charles Dow and Edward

Jones in 1884. Later, in the 1960s, the S&P 500 was conceptualised. In India, the BSE Sensex

was created in the 1990s and the S&P CNX Nifty followed soon after.


26 27

“I get it,” said Mini trying to disguise a yawn. “When the newspapers say that

the Nifty is going up, it means that there may be some stocks that are losing

value but over all, the prices of most stocks in that category are rising…”

“Exactly!” said Shiv. “And today, Nilesh told me that it is possible to invest in the

index. So, just imagine the convenience with which we can invest and at the

same time make money that is indexed to the Nifty or some other leading

index.”

“I have just one last question before I go off to bed: Exactly how can we invest in

the index?” asked Mini. “Well,” smiled Shiv ruefully, “I'll find out from Nilesh on

Monday morning.” That night, long after Mini had gone off to bed, Shiv sat at his PC at home and

read up about various domestic and international indices.

Some Broad Indian indices

S&P CNX Nifty

The S&P CNX Nifty (popularly called the Nifty 50) is the most favoured index for

large companies listed on the National Stock Exchange of India (NSE). The

Index is owned and managed by India Index Services and Products Ltd. (IISL).

IISL is the first Indian company whose core business activity is the

maintenance of indices. It is a joint venture between the NSE and CRISIL. It

also has a consulting agreement with Standard & Poor's (S&P). This index gets

its name- S&P CNX from S&P - Standard & Poor's; C – CRISIL; N – NSE; X – Index

The S&P CNX Nifty is computed using the market value weighted average

method. It comprises of 50 stocks which are traded on the NSE. These stocks

represent around 21 diverse sectors. Nifty stocks represented about 47.14 per

cent of the total market capitalization as on September 30, 2008.

VARIOUS STOCK MARKET INDICES

S&P CNX Nifty Junior

The Nifty Junior index comprises of scrip No 51 to scrip No 100 of the most

liquid scrips on the NSE, i.e. the 50 most liquid scrips after the ones in the Nifty

index. It may be useful to think of the Junior Nifty as an incubator for the Nifty,

as scrips from Junior Nifty, which qualify for Nifty, go out of the Junior Nifty and

enter the Nifty.

The maintenance of the S&P CNX Nifty and the CNX Nifty Junior are

synchronized so that the two indices will always be disjoint sets; i.e. a stock will

S&P NIFTY - Oct 1998 to Sept 2008

Companies comprised in the Nifty as on 30th September 2008

ACC Ltd., Ambuja Cements Ltd., Bharat Heavy Electricals Ltd., Bharat Petroleum

Corporation Ltd., Bharti Airtel Ltd., Cairn India Ltd., Cipla Ltd., DLF Ltd., GAIL (India)

Ltd., Grasim Industries Ltd., HCL Technologies Ltd., HDFC Bank Ltd., Hero Honda

Motors Ltd., Hindalco Industries Ltd., Hindustan Unilever Ltd., Housing Development

Finance Corporation Ltd., I T C Ltd., ICICI Bank Ltd., Idea Cellular Ltd., Infosys

Technologies Ltd., Larsen & Toubro Ltd., Mahindra & Mahindra Ltd., Maruti Suzuki India

Ltd., NTPC Ltd., National Aluminium Co. Ltd., Oil & Natural Gas Corporation Ltd.,

Power Grid Corporation of India Ltd., Punjab National Bank, Ranbaxy Laboratories Ltd.,

Reliance Communications Ltd., Reliance Industries Ltd., Reliance Infrastructure Ltd.,

Reliance Petroleum Ltd., Reliance Power Ltd., Satyam Computer Services Ltd., Siemens

Ltd., State Bank of India, Steel Authority of India Ltd., Sterlite Industries (India) Ltd., Sun

Pharmaceutical Industries Ltd., Suzlon Energy Ltd., Tata Communications Ltd., Tata

Consultancy Services Ltd., Tata Motors Ltd., Tata Power Co. Ltd., Tata Steel Ltd., Unitech

Ltd., Wipro Ltd., Zee Entertainment Enterprises Ltd.

Back To Basics

28 29

never appear in both indices at the same time. Hence it may be meaningful to

pool the S&P CNX Nifty and the CNX Nifty Junior into a composite 100 stock

index or portfolio. CNX Nifty Junior represented about 6.38 per cent of the total

market capitalization as on September 30, 2008.

S&P CNX 500

The S&P CNX 500 (base year: 1994) is India's first broad based benchmark of

the Indian capital market. The S&P CNX 500 represents about 86.54% of total

market capitalization and about 78 per cent of the total turnover on the NSE as

on September 30, 2008.

The S&P CNX 500 companies are disaggregated into 72 industry indices viz.

S&P CNX Industry Indices. Industry weightages in the index reflect the industry

weightages in the market E.g. if the banking sector has a 5% weightage in the

universe of stocks traded on NSE, banking stocks in the index would also have

an approximate representation of 5% in the index.

BSE Sensex

The Sensex, or more formally - the Bombay Stock Exchange Sensitive Index,

consists of 30 of the most briskly traded stocks on the Bombay Stock Exchange

(BSE). These stocks alone comprise a large portion of the market

capitalization of BSE. The base year of the BSE Sensex is 1978-79 and it is

computed by using the free float value-weighted market index method. The

constituent companies' stocks are reviewed and modified at regular intervals.

CNX Nifty Junior - Oct 1998 to Sept 2008

ETFs AND INDEXING

Companies comprised in the S&P CNX Nifty Junior as on 30th September 2008

Aditya Birla Nuvo Ltd., Andhra Bank, Apollo Tyres Ltd., Ashok Leyland Ltd., Asian Paints

Ltd., Aventis Pharma Ltd., Axis Bank Ltd., Bank of Baroda, Bank of India, Bharat

Electronics Ltd., Bharat Forge Ltd., Biocon Ltd., Cadila Healthcare Ltd., Canara Bank,

Chennai Petroleum , Corporation Ltd., Container Corporation of India Ltd., Corporation

Bank, Cummins India Ltd., GMR Infrastructure Ltd., Housing Development and

Infrastructure Ltd., IDBI Bank Ltd., IFCI Ltd., ING Vysya Bank Ltd., Indian Hotels Co. Ltd.,

Indian Overseas Bank , Infrastructure Development Finance Co. Ltd., JSW Steel Ltd.,

Jaiprakash Associates Ltd., Jindal Steel & Power Ltd., Kotak Mahindra Bank Ltd., LIC

Housing Finance Ltd., Lupin Ltd., Moser Baer India Ltd., Mphasis Ltd., Mundra Port and

Special Economic Zone Ltd., Nirma Ltd., Oracle Financial Services Software Limited,

Patni Computer Systems Ltd., Power Finance Corporation Ltd., Raymond Ltd., Reliance

Capital Ltd., Reliance Natural Resources Ltd., Syndicate Bank, Tata Teleservices

(Maharashtra) Ltd., Tech Mahindra Ltd., UltraTech Cement Ltd., Union Bank of India,

United Spirits Ltd., Vijaya Bank, Wockhardt Ltd.

S&P CNX 500 - Oct 1998 to Sept 2008

BSE Sensex - Oct 1998 to Sep 2008


30 31

As on 30th September, 2008, the BSE Sensex

stocks represent 45.92% of the market

capitalization on the BSE.

A Sector Specific Indian Index

CNX Bank Index

CNX Bank Index (base year: 2000) is an index comprised of the most liquid and

large capitalised Indian Banking stocks. It provides investors and market

intermediaries with a benchmark that captures the capital market

performance of Indian Banks.

Some US indices

S&P 500

S&P 500 is an index comprised of 500 stocks of large-cap corporations. It

covers about 75 per cent of all US equities. Thus, it is nearly representative of

the entire US stock market.

This index was created on the 4th March, 1957. Prior to that, an S&P stock

market index of 90 industries, called the S&P 90, existed. The S&P 500 was

introduced as a real-time index, which was calculated by a computer. All the

stocks in this index are large companies trading on the New York stock

exchange and NASDAQ. The ownership and maintenance of this index rests

with Standard & Poor's, who are a part of McGraw-Hill.

The S&P 500 is computed using a floating market-value weighting method i.e.

only those shares available for trading in the market are considered.

Previously, this index was calculated by the market value weighted method.

The transition to the present method was done in 2005, in an attempt to depict

market trends more realistically. A committee selects the constituent

companies, which are a part of this index.

The index includes volatile "growth stocks" and less volatile "value stocks".

Thus, the index is broad-based and depicts nearly the entire US stock market.

Some non-US companies are also constituted in this index. A large number of

fund managers of index funds and ETFs follow the performance of the S&P

500. The S&P 500 is also used as a benchmark by mutual fund companies to

evaluate their performance.

Dow Jones Industrial Average (DJIA)

The 'Dow 30' or 'The Dow', as this index is popularly called, consists of the

stocks of 30 of the most widely held and largest pubic companies of America.

Charles Dow created this index along with Edward Jones. Charles Dow was the

editor of the Wall Street Journal in the nineteenth century. He was also the

Companies comprised in the BSE Sensex as on 30th September 2008

ACC Ltd., Bharat Heavy Electricals Ltd., Bharti Airtel Ltd., DLF Ltd., Grasim Industries

Ltd., HDFC, HDFC Bank Ltd., Hindalco Industries Ltd., Hindustan Unilever Ltd., ICICI

Bank Ltd., Infosys Technologies Ltd., ITC Ltd., Jaiprakash Associates Ltd., Larsen &

Toubro Limited, Mahindra & Mahindra Ltd., Maruti Suzuki India Ltd., NTPC Ltd., ONGC

Ltd., Ranbaxy Laboratories Ltd., Reliance Communications Limited, Reliance Industries

Ltd., Reliance Infrastructure Ltd., Satyam Computer Services Ltd., State Bank of India,

Sterlite Industries (India) Ltd., Tata Consultancy Services Limited, Tata Motors Ltd., Tata

Power Company Ltd., Tata Steel Ltd., Wipro Ltd.

The easiest and surest way for a fund to

achieve the top quartile in investment performance among peer funds is to achieve the

bottom quartile in expenses - John Bogle, founder and retired CEO of The

Vanguard Group


32 33

co-founder of Dow Jones & Company. The Dow

Jones Industrial Average (DJIA) was first

published on the 26th of May 1896. At that time it

was the average of stocks of twelve vital

American companies.

The 30 stocks comprising the DJIA are changed

with changing market conditions. The selection

of the 30 stocks lies in the hands of the 'The Wall

Street Journal' editors. Interestingly, General

Electric is the only company that has existed as a

part of DJIA from the beginning till now.

For purposes of calculation, the value of the index is arrived by dividing the

composite value of constituent stocks by the total number of stocks.

There have been some common criticisms regarding this index. Critics feel that

the DJIA includes only 30 stocks, which cannot be a proper indication of the

trends of such a broad market like the US. Further, it is computed as a price-

weighted average, which is not a very good method of constructing indices. The

S&P 500 or the Dow Jones Wilshire 5000, computed by the float-adjusted

market value weighted method, are better indices to examine the trends in the

US market.

Dow Jones Wilshire 5000

Being a broad based stock market index, the Dow Jones Wilshire 5000 depicts

a picture of the entire American stock market. Companies which are included

in this index are listed on the New York stock exchange, the NASDAQ or the

American Stock Exchange.

This index goes way back to 1974. While it was created by Wilshire Associates,

Dow Jones & Company assumed responsibility of maintenance and

calculation of this index in April 2004. Thus, it was renamed as the "Dow Jones

Wilshire 5000'.

The Wilshire 5000, as it is popularly called, is computed on the basis of the

market capitalization-weighted method. Another index based on a float-

adjusted market capitalization method is also constructed. The companies

that constitute the index are revised and updated every month.

NASDAQ-100

NASDAQ-100 is an adapted market value-weighted index of the NASDAQ stock

exchange. It was created on the 31st January, 1985 and comprises of 100

large domestic and international companies listed on the Nasdaq stock

exchange. A slightly modified market value-weighted method is used to

calculate the index. A significant feature of this index is that it does not include

any financial companies. This is because the NASDAQ-100 and NASDAQ

Financial -100 were introduced on the same day. Thus, the NASDAQ-100 does

not take into account stocks of financial companies. Further, there are

stringent standards that a company must comply with to be included in the

NASDAQ-100 index. Normally, the index is rebalanced only once in a year.

However, in situations of delisting, bankruptcy and mergers, the composition

changes more frequently. It is abbreviated as the NDX.

A special highlight of this index is that it includes international stocks also. In

fact, Infosys, a home grown IT company finds a place in the NASDAQ 100.

Question: So investors shouldn't delude themselves

about beating the market? Answer: "They're just not going to do it. It's just not going to

happen.” - Daniel Kahneman, Nobel Laureate in

Economics, 2002


34 35

Comparisons of Indices

Index

S&P CNX

Nifty

S&P CNX

Nifty Junior

S&P CNX 500

BSE Sensex

CNX Bank

Index

S&P 500

DJIA

Dow Jones

Wilshire 5000

Nasdaq 100

Country

India

India

India

India

India

US

US

US

US

Stock

Exchange

National

Stock

Exchange

National

Stock

Exchange

National

Stock

Exchange

Bombay

Stock

Exchange

National

Stock

Exchange

NYSE &

NASDAQ

NYSE

NYSE,

NASDAQ

& American

Stock

Exchange

NASDAQ

Base date

November

3rd, 1995

November

3rd, 1996

June

7th, 1999

January

1st, 1986

January

1st, 2000

March

4th, 1957

May

26th, 1896

January

29th, 1999

January

31st, 1985

Methodology

Market

capitalization

weighted

Market

capitalization

weighted

Market

capitalization

weighted

Free-float

Method

Market

capitalization

weighted

Market

capitalization

weighted

Price weighted

Market

capitalization

weighted

Market value

weighted

Number of

constituting

stocks

50

50

500

30

12

500

30

5000

100

ETF Indexing Chapter2

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