Investing through the index

As it provides a summarised view of a basket of stocks, keeping its track will help in comparing performance and forecasting

With the National Stock Exchange’s benchmark index S&P CNX Nifty moving up more than 12 per cent in the past two months, if the market continues to gain like this, the annual returns for the calendar year for its investors could be in excess of 70 per cent – a really spectacular number indeed. But given that the outlook for the rest of the year is still not very clear, investors are advised not go overboard with the initial spike seen so far in 2012.

However, there would be an interest to invest in equities, as things are beginning to look up as well. The safe way to do this would be looking at index investing.

 

An index provides a summarised view on stocks and their prices. It enables the market participants to make sense of the change in stock prices.
 

HOW TO USE AN INDEX

• Investors who do not know which individual stocks to invest in can use the index as a method of choosing their stock investments by putting money in index based mutual funds. This gives investors the opportunity to do as good or bad as the markets or mirror its movements.
• Another benefit of stock market indices is that they provide a yardstick with which investors can compare the performance of their individual stock portfolios or mutual funds.
• The indices can also be used as a forecasting tool. By studying the historical movement of the indices, you can try to forecast market trends.
• Indices can also be used to track how the market reacted to specific events like poor monsoon, rise in interest rates, elections, Budget announcements and even global events. By studying the past data, you can forecast the way the market would behave in case same event happens again.
• Technical analysts use indices to analyse market trends and price movements.

 

PERFORMANCE
Index	Absolute returns (%)*
BSE Sensex	13.8
BSE FMCG	2.7
BSE TecK	6.5
BSE 100	17.5
BSE 200	17.8
BSE Capital Goods	27.1
BSE Metal	28.6
BSE Bankex	29.3
BSE Realty	37.4
*Based on closing value as on March 01, 2012  over Dec 30, 2011

The index is built on select stocks which are important and can be considered as a representative of the general market movements.

However, there are other uses from an index as well. They can be used to measure the performance of mutual funds. Each fund is required to be benchmarked against a relevant index to see how a particular fund is performing relative to the performance of the broader market. They are used for index derivatives (financial products whose value is derived from the level of a particular index). Also, they are used by index funds which invest passively in the stocks of a particular index instead of trading actively.

The stocks selected for index construction are based on market capitalisation or size, liquidity, free float (number of shares available for trading on the stock exchanges), industry group representation and so on. As a result an index may not be a good representation of the market as a whole.

Some of the sectors such as auto ancillaries and consumer durables or sunrise sectors are not represented in the Bombay Stock Exchange’s (BSE)Sensex or Nifty. Therefore, if you happen to have investments in such sectors, a better benchmark could be the the broader indices such as the BSE 200 or even BSE 500 or Sectoral indices are a better representation of such companies.

There are a number of indices and they are quite wide in capturing the market mood. The indices such as BSE Sensex or Nifty are good starting points. But remember, investors may have to look beyond them when it comes to understanding market movements. For example, it is possible that when the Sensex or Nifty may have given good returns, the mid-cap stocks or information technology (IT) stocks, however, would have been lagging behind.

In some cases, the mid cap stocks may give better returns than the large cap stocks. On the other hand, the booming Sensex may be driven by just one particular sector like capital goods, while a sector like IT may have been doing quite poorly. The bottom line: Do not just look at movements of the Sensex or Nifty. Look at other indices such BSE FMCG (Fast Moving Consumer Goods), BSE TecK (Technology), BSE Auto, BSE Metal and so on.

As one can see from the table, although the BSE Sensex has moved up by 13.8 per cent in the last two months, others like BSE FMCG and BSE Teck have underperformed, whereas riskier sectoral indices such as BSE Metal and BSE Realty have gone up by more than 25 per cent during this period. Interest rate sensitive index BSE Bankex has gone up by 37 per cent.

A word of caution, though: The Sensex and Nifty are used for tracking overall market movements, and the shares you have invested in may or may not behave in the same manner as the benchmark index. When the Nifty or Sensex goes down by say two per cent in a day, there may be stocks in the index that may go up. For example, when the equity market was in a bearish phase until recently, Cipla had given good returns.

The composition of stocks in an index changes over a period of time. Stocks such as Century Textiles, ACC, Tata Tea which were prime movers of the BSE Sensex during yesteryears, are no longer in the index. Similar stocks which are usually currently in vogue find a spot in the indices. Some of the stocks presently in the index may or may not be there in future years too. A stock’s spot in the index depends on the factors such as market capitalisation and so on.

Although the indices are best representative of market movement, investors need to do in depth study to use it optimally. By proper study and analysis of indices, investors can create good wealth for themselves by investing in index funds or trading in index based derivatives or even choosing to invest in quality stocks in the index such as Infosys, State Bank of India, Tata Consultancy Services, BHEL and so on.

---

The writer is a freelancer