An Index is like an indicator or a marker. It shows you a level. On its own, it does not have any meaning, but comparing it to its historical levels, it can show trends and provide insights. In the stock market context, why is an index needed in the first place? We all know that there are a lot of companies listed on the markets. The Indian stock markets have more than 5,000 companies listed on them. We would have to calculate the net movement of all these companies on a daily basis to understand whether the markets went up or down each day. With increased computing power, it may be possible to do so today with some difficulty, but it would have been impossible a couple of decades ago.
Very few of us would have experienced those days before 1979 when the stock market had no index to represent it. People would suddenly realise that a market operator made millions and conversely, someone quickly went bankrupt. The lack of indices and therefore understanding of trends led the belief - which still exists to some extent today - that the stock market is a ‘Satta Bazar’ or pure speculation.
In 1979, the BSE-Sensitive Index, also called the BSE Sensex was first set up by including the top 30 companies in it. The index was created in a way that the weight of each company stock in it was based on the size of the company. These are called ‘market cap weighted’ indices and are most popular as they consider a more practical weight of each company. The other way to create an index from a set of companies is to give them the same weight. Those are called ‘equally weighted’ indices.
Another thing to note is that while individual stocks are traded and reported in Rupees, indices have no units. They are just numbers and therefore need to be compared to something relevant, always. As the Sensex started logging in numbers based on a 100 level that it started with, it created a historical data base that could be analysed in many ways.
One of the more direct benefits of these data points that have been created is in the field of Technical Analysis. Technical analysts who look at charts created by collating daily/weekly/monthly data points can use their skills to study trends and predict what could happen next. Even a layman can identify trends in the market by realising that we are in a bull run if the index readings are rising every day and vice versa for a bear market.
Another benefit of indices is for market participants who deal in the derivatives markets, i.e. the futures and options markets. As indices are made up of several underlying companies, it becomes that much more difficult to manipulate an index as compared to individual stocks making them safer for derivative trading. Also, as the indices average out the movement of the underlying stocks, some going up and some down, they tend to be more stable than individual stocks. Thirdly, for the above reasons, as the derivative markets have developed, liquidity in futures and options based on popular indices is the highest, making trading into and out of them much more easier.
Leading indices can be used to create Index funds and Index ETFs for investors who want to participate in the markets without any further risk of a sector/ style or manager. The difference between a fund and an ETF is that funds are mostly open ended and units can be bought or sold every day once at the end of the day valuation, while ETFs are traded on the exchanges and afford the opportunity to buy or sell them anytime during the market open hours, just like any other stock, at prices that are correlated to the NAV of the ETF.
ETFs are gaining rapid popularity around the world and in India too, primarily because they have very low cost of operation. With no stock selection and therefore no research and fund management requirement - you just allocate new money in the same proportion as the current weight of each of the stocks in the index - the need to hire expensive resources is done away with for such funds.
While ETFs based on leading indices are the most popular and provide an overall exposure to the equity markets, for the more informed investors, there are several other ETFs based on either market caps, or sectors or even themes like Banking & Financial Services (BFSI) ETFs, Public Sector Undertakings (PSU) ETFs etc. The exchanges are now creating several customised and new-age indices to track certain trends in the markets.
These include Shariah indices, ESG or Environment, Social & Governance-based Indices. There are now ETFs available for these and practically any theme or idea that one may have. So learn more about indices, know what they represent and see if they can help you in your investment journey.
(The author is the founder of Five Rivers Portfolio Managers and can be reached at pankaj@5riversindia.com)