Introduction

What is an Index?
Any Index is used to give information about some system or financial markets. Financial Indexes are constructed to measure price movements of stocks, bonds, and other investments. Stock market Indexes are meant to capture the overall behaviour of equity markets. It is created with a group of stocks that are representative of the whole market or a specified sector or segment of the market. Any Index is calculated with reference to a base period and a base Index value.
 

What are the uses of Indexes?    Traditional uses
	Indicator of Market Movement / Returns
	Indexes reflect highly up-to-date information
	Lead indicator of the economy
Higher Applications
	Index Funds - Passive Fund Management
	Index Derivatives - Index Futures and Index Options

What is Indexing ?
"Indexing" is an investment approach that seeks to match the investment returns of a specified stock market benchmark, or Index. When Indexing, an investment manager attempts to replicate the investment results of the target Index by holding all -- or in the case of very large Indexes, a representative sample -- of the securities in the Index. There is no attempt to use traditional "active" money management or to make "bets" on individual stocks or narrow industry sectors in an attempt to outpace the Index. Thus, Indexing is a "passive" investment approach emphasizing broad diversification and low portfolio trading activity.

An Index fund is a mutual fund scheme that invests in the securities of the target Index in the same proportion or weightage. Though they are designed to provide returns that closely track the benchmark Index, Index funds carry all the risks normally associated with the type of asset the fund holds. So, when the overall stock market falls, you can expect the price of shares in a stock Index fund to fall, too. In short, an Index fund does not mitigate market risk -- the chance that the overall market for bonds or stocks will decline. Indexing merely ensures that your returns will not stray far from the returns on the Index that the fund mimics.

The underlying assumption of Indexed management is that financial markets are efficient over the long term, making it virtually impossible for active managers to consistently outperform market averages consistently. For this reason, Indexing has become popular with corporate pension fund managers who seek steady returns through a conservative, long term, low-risk investment strategy.

Evolution of Index funds

As equity markets in U.S evolved and became more sophisticated, the fund managers found it more and more difficult to outperform the Index net of trading costs, broker commissions, market spreads and taxes. It has been seen that over the last 20 years over 85% of active fund managers have underperformed the S&P 500. To add to that, as the mutual fund industry grew in size, it became difficult to say that a fund manager who had outperformed the Index this year would be able to do the same year after year. Realising this, it was felt that if it was difficult to beat the Index consistently, one could atleast get Index returns.

Thus, many Investment managers purchased stocks in proportion to the Index, either knowingly or simply by default. As a result this process became to known as closet Indexation. Out of this evolved the idea of a passive buy and hold portfolio with a reduced trading cost and with a greater control over the portfolio risk. These factors along with technological advancement formed the foundation for the development of Index funds.

Well Fargo bank pioneered Index funds offering its first product in 1971 with a $ 6 million contribution from the Samsonite pension fund. The growth in Index funds thereafter has been a natural consequence of increased emphasis on equity investment by institutional investors around the world. However, in the US markets, the growth in Index funds and Index products gained momentum only from 1996

Why Indexing?
Index funds in comparison to actively managed funds are better in the following aspects:
   1. Lower expense ratio
   2. Lower transaction costs
   3. Better control of risk through greater diversification.
   4. Difficult to consistently beat the market
   5. Less prone to the risk of fund manager’s performance

1. Low expenses: Index fund is a less expensive form of investment than actively managed funds. Index funds do not require the services of high price portfolio managers, analytical work of security analysts, etc. Portfolio management of Index funds is much less labor intensive than that of actively managed funds.

2. Transaction costs: They are the charges incurred when one enters the market in order to buy or sell securities. The burden of transaction costs depends on two factors :-

   • The average cost per transaction: It reflects both the broker’s commissions and the hidden cost, which is impact cost. Impact Cost is the percentage degradation over and above the ideal price. For liquid securities this cost is low while for illiquid ones it is high.

   • Portfolio Turnover: As the objective of an Index fund is to mimic the Index, a fund manager does not need to keep changing his portfolio like in the case of active fund management. He would need to change his portfolio only if there is a change in the Index constituents.

   Thus, Index Fund is a low cost concept. These savings in costs taken over a long period of time result in substantial gains for the investor.

3. Low risk through diversification: Market Indexes are constructed to represent performance of the stock market as a whole. The constituents of an Index would represents the largest and most liquid companies from different sectors of the economy. By diversifying, the company specific risk is largely reduced.

4. Difficult to consistently beat the market: Though active fund managers have been able to beat the market in certain years, it becomes difficult to say whether they would be able to do so consistently. Moreover, the underlying assumption of Indexed management is that financial markets are efficient over the long term, making it virtually impossible for active managers to consistently outperform market averages. Experience in the US has shown that in the last 20 years, over 80% of the actively managed funds have underperformed the benchmark S&P 500.
   
   
    

5. Less prone to the performance risk of the fund manager: An Index fund manager’s job is limited to the extent of tracking the Index as closely as possible. In actively managed funds the investments are at the stake of the fund manager’s performance. Thus an actively managed fund is totally exposed to the risk of fund manager’s performance.

Types of Index funds

Index funds Vs Non Index funds

Tracking Error
Tracking error is defined as the annualised standard deviation of the difference in returns between the Index fund and its target Index. In simple terms, it is the difference between returns from the Index fund to that of the Index. An Index fund manager needs to calculate his tracking error on a daily basis especially if it is open-ended fund. Lower the tracking error, closer are the returns of the fund to that of the target Index. Tracking Error is always calculated against the Total Returns Index which shows the returns on the Index portfolio, inclusive of dividend.

Tracking error indicates

Choosing the Right Index
The aim of an Index fund is to match as closely as possible the returns of its target Index. This makes it all the more essential to choose the right Index. In most cases around the world today, market Indexes were created years ago, in an environment with limited information access, poor computation and limited knowledge of financial economics. However, all three factors are much altered today. Over the last two decades, the revolution in technology and greater research into Index funds and Index derivatives has shed new light upon issues of Index construction.

Every stock market Index is a trade-off between diversification and liquidity. Small market Indexes are liquid but under-diversified while large market Indexes tend to be well-diversified but illiquid. Hence an Index that that has the right mix of both would be the best Index. Thus the characteristics of a good Index should be :-
• Representation of the market
• Well diversified
• Highly Liquid
• Calculation of Total Returns
• Professionally managed

The S&P CNX Nifty
In India, the S&P CNX Nifty is the most scientific Index that was constructed keeping in mind Index funds and Index derivatives.

The S&P CNX Nifty is a market capitalisation-weighted Index with base year as November 03, 1995. The base value has been set at 1000. The S&P CNX Nifty is an event-driven Index i.e., price change in any of the Index securities will lead to a change in the Index. It also takes into account substitutions in the Index set and importantly, corporate actions such as stock splits, rights, etc without affecting the Index value. For the purpose of Indexation, market cap weighted Index offers the advantage of simplifying the day to day management of the fund. As market prices rise or fall, the value of the Index fund rises and falls in tandem with the target Index. Since market price change does not require any rebalancing, there are savings in the number of transactions, thus reducing transaction cost.

The construction of the S&P CNX Nifty was motivated by the need to create a methodology to intelligently address the following four major issues in Index creation:-
	Evolution of an Index set India’s corporate sector is dynamic: old companies go defunct, and IPOs (including newly-disinvested public sector companies) frequently turn into some of the largest companies in the country.
	The problem of stale prices The market Index should reflect market conditions at a point in time – when some components trade infrequently, they detract from this objective. Stringent liquidity conditions should be applied so as to minimise the difficulties caused by non-synchronous trading, and its more extreme version, non-trading.
	The size of the Index set Should an Index set comprise 30, or 50, or 100, or 3000 stocks ? We should have a clear quantitative foundation for implementing the choice of the set size.
	Modern applications The Index should have liquidity of a form which is well-suited for modern applications such as Index funds and Index derivatives, both of which require the entire Index set to be treated and traded as a portfolio.

An Index Committee consisting of eminent personalities in the field of finance such as mutual fund managers, trading members, academicians and persons who have experience trading in futures and options markets abroad, designed the S&P CNX Nifty so as to make it more representative of the entire market, provide high hedging effectiveness for any portfolio and minimise impact cost of transactions.

Among the biggest findings of the committee was that the number 50 was found to be the ideal size of the Index and that liquidity should be judged by impact cost. It is indeed the case that putting more stocks into the Index yields more diversification. However, two things go wrong when we do this too much: Firstly, there are diminishing returns to diversification. Going from 10 stocks to 20 gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks to gives almost zero reduction in risk. Hence, there is little gain by diversifying, beyond a point. The more serious problem is the inclusion of illiquid stocks due to diversification.

Liquidity of the asset is one of the most important criteria for an investor. In the derivatives market, investors are more concerned with the liquidity of the underlying. All the securities constituting the S&P CNX Nifty are highly liquid. Liquidity of the S&P CNX Nifty is important in reducing the reflection of stale prices and in enabling spot-to-futures arbitrage.

A variety of measures such as trading volume, trading frequency, bid-ask spread etc are used for quantifying liquidity. For measuring liquidity of Nifty securities, their impact costs have been calculated. Impact cost of a security as the term suggests, is the cost of executing a transaction in the given security in proportion of its weightage in the portfolio under consideration, on immediate basis at any point of time in the market.

Selection Criteria
	All companies to be included in the Index should have a market capitalisation of Rs. 5 billion or more
	Company entering the Index should have double the market capitalisation of the company leaving the Index
Liquidity (Impact Cost)
	All securities should fully satisfy the required execution on 90% of the trading days at an impact cost of less than 0.75% in the last six months.

Total Returns Index
A Total Returns (TR) Index is calculated on S&P CNX Nifty. This Index shows the returns on the Index portfolio, inclusive of dividend. The difference between the two Indexes Nifty and TR Index at any given time is the return obtained on reinvestment of dividends through the intervening period. Thus it is the ideal benchmark for Index Funds which earns dividend and