Basics
What should a stock market
index be ?
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.
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What do the ups
and downs of an index mean ?
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.
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What is the
basic idea in an index ?
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 return 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. That is what the index will capture.
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What kind of
averaging is done for calculation of an index ?
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.
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Why are indexes
important ?
Traditionally, indexes 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 indexes 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, indexes 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 par 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 indexes.
Finally, indexes serve as a benchmark for
measuring the performance of fund managers.
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What kinds of
indexes exist ?
The most important type of market index
is the broad-market index. In most countries, a single major index dominates benchmarking,
index derivatives and research applications. In addition, more specialised indexes 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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