This is Part -2 of the write-up What is Index? For Part 1 Click

Continued… What is Index?

Here is some more information on the Index & FAQs on Nifty & Sensex.

Benefits of considering Indices to analyze the movement of the stock market

An index can be used as a benchmark making it easy for an investor to compare the performance of various stocks.

SENSEX and NIFTY are often used as benchmarks in India to find out if a stock has outperformed or underperformed the market by comparing the index and the stock price. This also helps investors to identify market trends with ease.

Many investors prefer to have a portfolio of securities that closely resembles an index. They simply rely on the index for stock selection (called the Passive Investment strategy).

As a result, their portfolio returns match those of the index in most cases. For instance, if SENSEX gave 10% returns in one month, then the investor’s portfolio which is mirroring the index scrips is likely to give the same percentage of returns.

Indices tell us about the health of the industry in which an investor has invested. If a person following SENSEX sees a drop that continues for some days, he/she might have to analyze his/her portfolio to either buy or sell certain stocks.

Some salient benefits that you can reap by following movements of the stock market indices are mentioned below –

• Stock indices reflect information that is updated on a real-time basis. Hence, they provide an easy way to track the overall financial health, making it the lead indicator of the overall performance of the economy.
• The historical data of index movements and prices can also provide some guidance to the investors about the market reactions to certain scenarios in the past. This enables them to balance their portfolios accordingly.
• Indices show trends and changes in investing patterns, providing a yardstick for comparison.

Modern financial applications such as index-based funds, index futures, and index options play an important role in financial investments and risk management.

Some popular Market Indices across the globe

The S&P 500 is one of the world’s best known stock markets indices. It includes 70% of the total stocks traded in the United States of America.

The Dow Jones Industrial Average (DJIA), another very well-known index, measures 30 stocks traded on the New York Stock Exchange and NASDAQ. These companies include premier corporations such as General Electric Company, Walt Disney, Exxon Mobil Corporation, Microsoft Corporation etc.

The NASDAQ Composite index reflects prices of the 4,000 stocks traded on the NASDAQ.

Active and Passive Investment funds

There is a difference between actively managed and passively managed investment funds. Knowing the difference can help you understand which one suits your investment needs better than the other.

Mostly, your choice will depend on the amount of risk you are willing to take with your money. When investment funds are actively managed, there is a professional fund manager or a core team which decides where the fund’s money should be invested.

In contrast, a passively managed fund does not have a management team making investment decisions as they need simply follow a market index, like SENSEX or NIFTY and therefore, charge less fee to investors.

The finance world is divided on its views about the efficacy of each one. Active funds are generally better performers as they can beat the market index in terms of returns in the long run.

Passively managed funds, purchase and sell stocks to maintain the relative position in portfolio as per the benchmark index. So, if you have put your money in a fund that follows NIFTY 50, then your performance is going to mimic the performance of NIFTY 50. Common examples of passive funds are Index Funds and ETFs (Exchange Traded Funds).

Index Funds

Because you cannot invest directly in an index, index funds are created to track their performance. Index funds, as the name suggests, invest in an index.

An index fund is a type of mutual fund which tracks the components of a stock market index and follows a set of specific rules regardless of the state of the market. These funds purchase all the stocks in the same proportion as in a particular index.

They perform in tandem with the index they are tracking, save for a small difference known as tracking error.

Index Funds are easier and more beneficial to invest in for a lot of reasons. They have relatively low operating expenses. An index fund might cost you a fraction of the actual expense ratio of most mutual funds. In addition to the lower cost, index funds can be a lower-risk investment.

They are a better choice for people who have a low-risk appetite as they provide a broad market exposure. A single index fund can be a potent combination of hundreds of securities that can distribute the risk evenly.

They are not traded as frequently as actively managed funds, they provide a low portfolio turnover and hence are more tax efficient.

Why does Index (SENSEX or NIFTY) move up or down?

Most of us, grapple with this question. Many of us wonder at the speed at which these indices change on screen. The answer lies in the way these indices are computed.

As explained above, any stock index reflects the changes happening in the market capitalisation of the underlying securities (which in-turn is mostly a function of price of the security).

Generally, there are hundreds of trades happening at different prices in the underlying securities every minute during market hours. Trades happen at different prices because brokers or traders in the market have different perceptions or viewpoints on the same event or piece of market news.

If the news is considered positive, the stock price generally moves up, and vice versa. Therefore, the movement in index depends upon the aggregate or averaged movements in prices of underlying stocks.

For example, SENSEX which is constituted by 30 different companies will move up if there is good news about all the 30 companies on the given day and time. If the news is perceived as negative, then the index is expected to go down.

Mostly, the news are such that they are positive in case of some companies and negative for rest. There may not be any news in respect of some companies on a given day. So the direction and quantum of movement in index of that day and time, will be the averaged effect of movements in prices of 30 different companies.

It should also be remembered that all the stocks do not carry the same amount of impact on the index.

When an index either goes up or down, what does it signify?

The movements of an index in either direction and its degree, reflect the changing expectations of the stock market about future price or dividends of India’s corporate sector.

When the index goes up, the prospective dividends in the future are expected to be better than the past. In contrast, when prospects of dividends in the future become pessimistic, the index drops.

Why are stock indices important?

Indices are great information sources. They give an instant feel on how the market is performing. This information is valuable when an index reflects up to date information and this information, in turn, tells an investor how his/her individual portfolio is performing comparatively.

What is the calculation frequency for Nifty 50 and Sensex?

During market hours, prices of the index constituting Nifty 50 and Sensex stocks are automatically fed to a computer. Index is calculated on a real time basis and disseminated at an interval of 1 second. Index thus computed is continuously updated on all trading workstations connected to the Exchange trading system in real time.

Do Index have derivative products?

Like for individual stocks, derivative products are available for indices also. So BSE has futures product for popular index SENSEX. It comes in three different maturity periods namely one month, two months and three months.

Similarly, NSE currently provides trading in Futures and Options contracts on 9 major indices.