INDEX FUNDS

(Source: NSE Website-www.nseindia.com)

Introduction

What is an Index?

An 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. Stock market indexes are useful for a variety of reasons. Some of them are :

  • They provide a historical comparison of returns on money invested in the stock market against other forms of investments, such as gold and debt.
  • They can be used as a standard against which to compare the performance of an equity fund.
  • It is a lead indicator of the performance of the overall economy or a sector of the economy.
  • Stock indexes reflect highly upto date information.
  • Modern financial applications, such as Index Funds, Index Futures and Index Options play an important role in financial investments and risk management.

Index Concepts

In the investment world, however, risk is inseparable from performance and, rather than being desirable or undesirable, is simply necessary. Understanding risk is one of the most important parts of a financial education.

Indices and index-linked investment products provide considerable benefits. But it is equally important to know the associated risk that comes as a part of such exposure. Important concepts and terminologies are associated with Indices. For example, Beta helps us to understand the concepts of passive and active risk. Impact cost represents the cost of executing a transaction in a given stock, for a specific predefined order size, at any given point of time. These concepts are important for understanding indices and investment opportunities.

Impact Cost

Liquidity in the context of stock markets means a market where large orders can be executed without incurring a high transaction cost. The transaction cost referred here is not the fixed cost typically incurred, like brokerage, transaction charges and depository charges. But it is the cost attributable to the lack of market liquidity as explained subsequently. Liquidity comes from the buyers and sellers in the market, who are constantly on the look out for buying and selling opportunities. Lack of liquidity translates into a high cost for buyers and sellers.

The electronic limit order book (ELOB) as available on NSE is an ideal provider of market liquidity. This style of market dispenses with market makers, and allows anyone in the market to execute orders against the best available counter orders. The market may thus be thought of as possessing liquidity in terms of outstanding orders lying on the buy and sell side of the order book, which represent the intention to buy or sell.

When a buyer or seller approaches the market with an intention to buy a particular stock, he can execute his buy order in the stock against such sell orders which are already lying in the order book, and vice versa. An example of an order book for a stock at a point in time is detailed below:

Buy

Sell

Sr.No.

Quantity

Price

Quantity

Price

Sr. No.

1

1000

3.50

2000

4.00

5

2

1000

3.40

1000

4.05

6

3

2000

3.40

500

4.20

7

4

1000

3.30

100

4.25

8

There are four buy and four sell orders lying in the order book. The difference between the best buy and the best sell orders (in this case, 0.50) is the bid-ask spread. If a person places an order to buy 100 shares, it would be matched against the best available sell order at 4, i.e,. he would buy 100 shares for 4. If he places a sell order for 100 shares, it would be matched against the best available buy order at 3.50, i.e., the shares would be sold at 3.5.

Hence if a person buys 100 shares and sells them immediately, he is poorer by the bid-ask spread. This spread may be regarded as the transaction cost which the market charges for the privilege of trading (for a transaction size of 100 shares).

Progressing further, it may be observed that the bid-ask spread as specified above is valid for an order size of 100 shares upto 1000 shares. However for a larger order size the transaction cost would be quite different from the bid-ask spread. Suppose a person wants to buy and then sell 3000 shares. The sell order will hit the following buy orders:

Sr. No.

Quantity

Price

1

1000

3.50

2

1000

3.40

3

1000

3.40

While the buy order will hit the following sell orders:

Quantity

Price

Sr. No.

2000

4.00

5

1000

4.05

6

This implies an increased transaction cost for an order size of 3000 shares in comparison to the impact cost for order for 100 shares. The "bid-ask spread", therefore, conveys transaction cost for a small trade.

This brings us to the concept of impact cost. We start by defining the ideal price as the average of the best bid and offer price, in the above example it is (3.5+4)/2, i.e. 3.75. In an infinitely liquid market, it would be possible to execute large transactions on both buy and sell at prices which are very close to the ideal price of 3.75. In reality, more than 3.75 per share may be paid while buying and less than 3.75 per share may be received while selling. Such percentage degradation that is experienced vis-à-vis the ideal price, when shares are bought or sold, is called impact cost. Impact cost varies with transaction size. For example, in the above order book, a sell order for 4000 shares will be executed as follows:

Sr. No.

Quantity

Price

Value

1

1000

3.50

3500

2

1000

3.40

3400

3

2000

3.40

6800

Total value

13700

Wt. average price

3.43

The sale price for 4000 shares is 3.43, which is 8.53% worse than the ideal price of 3.75. Hence, we say "The impact cost faced in buying 4000 shares is 8.53%".

Definition

Impact cost represents the cost of executing a transaction in a given stock, for a specific predefined order size, at any given point of time. Impact cost is a practical and realistic measure of market liquidity; it is closer to the true cost of execution faced by a trader in comparison to the bid-ask spread. It should however be emphasized that:

· impact cost is separately computed for buy and sell

· impact cost may vary for different transaction sizes

· impact cost is dynamic and depends on the outstanding orders

· where a stock is not sufficiently liquid, a penal impact cost is applied

In mathematical terms it is the percentage mark-up observed while buying / selling the desired quantity of a stock with reference to its ideal price (best buy + best sell) / 2.

Example A:

ORDER BOOK SNAPSHOT

Buy Quantity

Buy Price

Sell Quantity

Sell Price

1000

98

1000

99

2000

97

1500

100

1000

96

1000

101

TO BUY 1500 SHARES

Beta

Risk is an important consideration in holding any portfolio. The risk in holding securities is generally associated with the possibility that realised returns will be less than the returns expected. Risks can be classified as Systematic risks and Unsystematic risks.

  • Unsystematic risks:

    These are risks that are unique to a firm or industry. Factors such as management capability, consumer preferences, labour, etc. contribute to unsystematic risks. Unsystematic risks are controllable by nature and can be considerably reduced by sufficiently diversifying one's portfolio.

  • Systematic risks:

    These are risks associated with the economic, political, sociological and other macro-level changes. They affect the entire market as a whole and cannot be controlled or eliminated merely by diversifying one's portfolio.

What is Beta?

The degree to which different portfolios are affected by these systematic risks as compared to the effect on the market as a whole is different and is measured by Beta. To put it differently, the systematic risks of various securities differ due to their relationship with the market. The Beta factor describes the movement in a stock's or a portfolio's returns in relation to that of the market returns. For all practical purposes, the market returns are measured by the returns on the index (Nifty, Mid-cap, etc.) since the index is a good reflector of the market.

Methodology / Formula

Beta is calculated as :

where,

Y is the returns on your portfolio or stock - DEPENDENT VARIABLE

X is the market returns or index - INDEPENDENT VARIABLE

Variance is the square of standard deviation.

Covariance is a statistic that measures how two variables co-vary, and is given by:

Where, N denotes the total number of observations, and and respectively represent the arithmetic averages of x and y.

In order to calculate the beta of a portfolio, multiply the weightage of each stock in the portfolio with its beta value to arrive at the weighted average beta of the portfolio

Standard Deviation

Standard Deviation is a statistical tool, which measures the variability of returns from the expected value, or volatility. It is denoted by sigma(s). It is calculated using the formula mentioned below:

Where, is the sample mean, xi’s are the observations (returns), and N is the total number of observations or the sample size.

Total Returns Index

Nifty is a price index, and hence reflects the returns one would earn if investment is made in the index portfolio. However, a price index does not consider the returns arising from dividend receipts. Only capital gains arising due to price movements of constituent stocks are indicated in a price index. Therefore, to get a true picture of returns, the dividends received from the constituent stocks also need to be factored in the index values. Such an index, which includes the dividends received is called the Total Returns Index.

Total Returns Index reflects the returns on the index arising from (a) constituent stock price movements and (b) dividend receipts from constituent index stocks.

Methodology for Total Returns Index (TR) is as follows:

The following information is a prerequisite for calculation of TR Index:

  • Price Index close
  • Price Index returns
  • Dividend payouts in Rupees
  • Index Base capitalisation on ex-dividend date
  • Dividend payouts as they occur are indexed on ex-date.

    Indexed dividends are then reinvested in the index to give TR Index.

    Total Return Index = [Prev. TR Index + (Prev. TR Index * Index returns)] +
    [Indexed dividends + (Indexed dividends * Index returns)]

    Base for both the Price index close and TR index close will be the same.

    An investor in index stocks should benchmark his investments against the Total Returns index instead of the price index to determine the actual returns vis-à-vis the index.

    Investible Weight Factors (IWFs)

    Free-float methodology is globally regarded as an ideal methodology for calculation of equity indices. As per this methodology, free-float market capitalization of all index constituents is considered for calculation of the index. Free-float market capitalization of the index constituents is derived by applying IWFs on full market capitalization of respective companies in the index. This approach aims to limits the influence of a particular company in the index to the extent of its actual free float and reduces influence of large promoter/ strategic holding (which generally is not available for trading) on the index, thus making it truly investable.

    Free-float methodology in index calculation aids both active and passive investment strategies. Active managers are able to compare their portfolio return vis-à-vis the investable index, and at the same time passive fund managers are able to offer low-tracking error by introducing passive funds, such as index funds, exchange traded funds linked to investable indices calculated based on free-float methodology.

    IWF, as the term suggests, is a unit of floating stock expressed in terms of a number available for trading and which is not held by the entities having strategic interest in a company. Higher IWF suggests greater number of shares held by the investors as reported under public category within a shareholding pattern reported by each company.

    The IWFs for each company in the index are determined based on the public shareholding of the companies as disclosed in the shareholding pattern submitted to the stock exchanges on quarterly basis. The following categories are excluded from the free-float factor where identifiable separately:

    • Shareholding of promoter and promoter group
    • Government holding in the capacity of strategic investor
    • Shares held by promoters through ADR/GDRs
    • Strategic stakes by corporate bodies
    • Investments under FDI category
    • Equity held by associate/group companies (cross-holdings)
    • Employee Welfare Trusts
    • Shares under lock-in category

    For Example: For XYZ Ltd.

    Shares

    %

    Total Shares

    1,00,00,000

    100.00


    Shares

    %

    Shareholding of promoter and promoter group

    19,75,000

    19.75

    Government holding in the capacity of strategic investor

    50,000

    0.50

    Shares held by promoters through ADR/GDRs

    2,50,000

    2.50

    Equity held by associate/group companies (cross-holdings)

    12,575

    0.13

    Employee Welfare Trusts

    1,45,987

    1.46

    Shares under lock-in category

    14,78,500

    14.79

    IWF = [1,00,00,000 – (19,75,000 + 50,000 +2,50,000 +12,575 +1,45,987 +14,78,500)] / 1,00,00,000. = 0.60870

    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 at least 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 onwards.

    Types of Index funds

    a) Fully Replicated Funds: Fully Replicated Funds hold all the constituents of the chosen Index in the same proportion as held in the Index. This type of fund is expected to have the lowest tracking error.

    b) Sampled funds: If the benchmark Index is large in size (number of constituents) then fully replicated fund is likely to have a huge establishment and annual maintenance cost. In such cases, it may be easier and beneficial to select a sample from the target Index to represent the entire Index. Sampling enhances savings in transaction costs but on the flip side the tracking error is likely to be much higher.

    Index Funds

    Index Funds today are a source of investment for investors looking at a long term, less risky form of investment. The success of index funds depends on their low volatility, and therefore the choice of the index.

    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

    1. How closely the fund is tracking the Index: This refers to the fact that how close the weightages of the stocks in the portfolio are to the weightages of the stocks in the Index. The more closely the weightage of the stocks are tracked in the Index, the lower will be the tracking error. The factors that affect tracking error are inflows / outflows in the fund, corporate actions, change of Index constituents and the level of cash maintained in the fund for liquidity purposes.

    2. The cost that routinely subtracts from fund returns: Expenses like transaction costs including broker’ commission, bid and ask spread, etc. gets subtracted from the returns of the fund. Higher the expenses incurred, greater will be the tracking error.

    Calculation of tracking error

    Step 1:

    Obtain the NAV values and the TR Index values for each day of the total time period required.

    Step 2 :



    Calculate the percentage change in the NAV and TR Index for each day over its previous day.

    Percentage change in the NAV

    NAV as on day (t) – NAV as on day(t-1)
    = ----------------------------------------
    NAV as on day (t - 1)

    Step 3 :

    Calculate the difference between the percentage change in the NAV and the percentage change in the TR Index for each day.

    Step 4 :

    Calculate the standard deviation of the difference obtained from day(1) to day(n) in Step 3

    Step 5 :

    Calculate the annualized tracking error as per the formula given below:

    Annualised tracking error= Standard deviation obtained (Step 4)* sqrt(250)

    Reasons of Tracking Error

    The reasons for tracking error are:

    1. Expenditure incurred by the fund: Ideally all the corpus of the fund have to be invested in the securities of the benchmarked Index as the objective of the scheme is to mimic the returns of the underlying index. But it is not possible, as the Fund has to incur expenses towards its day to day management, transaction fees payable at the time of purchase or sale of securities, etc. The expenditure of the fund has to be met out of the corpus of the fund, which means that the fund will invest less funds than what it has collected. This in turns affects the returns as the fund will receive returns only on the amount which is invested. Hence, the lower the expenditure incurred by the fund, the lower will be the tracking error.

    2. Cash balance: The investment pattern of the fund provides for the asset allocation pattern. Ideally, the full corpus of the fund has to be invested in the underlying index. But this may not be possible due to the funds obligation to meet requests for redemption, receipt of dividend, etc. The fund has to set aside some amount of its corpus to meet the redemption request. As the redemption has to be made within a few days, the fund has to hold cash or other short terms assets which enable it to convert such instrument in cash. To provide for this exigency the fund has to keep aside some part of its corpus, and therefore is not able to investment all its corpus. Further, the fund may receive dividend on the shares held by it which should again be invested in the constituents of the benchmarked index, as soon as possible. If the fund is not able to invest such dividend then it holds more cash than required and hence its returns would be affected. Similar is with the cash of subscription for purchase of the units of the fund. So when the funds hold more cash, it has that much less to invest in the underlying index and thus it leads to a mismatch in the returns. It should be the endeavour of the fund to keep the right amount of cash, which at the same time can provide for redemption request and should not be ideal.

    3. Underlying securities breaching the upper or lower circuit:

    The fund has to rebalance its investment for which it has to buy or sell securities. Sometimes, it may happen that the fund is not able to buy or sell the underlying securities due to circuit filters imposed on it. Hence, the fund is not able to hold the required number of securities which could lead to it not mimicking the index fully. It may also happen that due to the circuit filters the fund is not able to buy or sell securities at the desired price, or at the same time when the rest of the underlying securities are purchase or sold. It might have to pay more to buy and receive less amount when it sells. This leads to distortion in the allocation of fund available to the portfolio of stocks.

    4. Giving effect to the corporate actions: Whenever there is a corporate action, such as debenture or warrant conversion, rights, merger, change in constituents, bonus, forfeiture and preferential issue. The fund has to realign its portfolio to the benchmarked Index. This leads to the buying and selling which adds up to the expenditure which again affects the returns of the fund. Also, the realignment has to be proper, otherwise there would be a mismatch in the investment in each security of the benchmarked Index vis-a-vis the actual weightage of each security in the benchmarked Index.

    In case of corporate actions, such as rights, bonus, conversion, merger or amlagamation, where the existing holders are benefited by receiving more shares. These corporate actions come into effect from the ex-date as announced by the Stock Exchanges. Usually, there is a time gap between the ex-date and the date on which the Fund is actually credited with that benefit and has the number of shares with itself. During this period, the Index represents the benefit but the Fund doesn’t. Sometimes if there is a redemption pressure or fresh investment during this period then it would be difficult for the fund to arrive at the precise portfolio to be sold or purchased as presently its scheme does not truly reflect the benchmarked Index.

    There may be cases were a constituent of the benchmarked Index has hived off one of its division into a separate company as per the scheme of amalgamation. Consequently, as per the scheme, it issues shares of the new company to the existing shareholders. This new company is not a constituent of the benchmarked Index and may not even be listed on the Stock Exchange for some time to come. This leads to the problem of valuation of this company and further, the proportionate amount invested in this company will not be as per the scheme of investment. This leads to a mismatch in the assets held by the Fund with that which is represented by the benchmarked Index. Whenever listed, this company has to be sold off and again the scheme has to be realigned with the benchmarked Index

    The new securities which are issued should be listed on the Stock Exchange where the trading takes place at present. Sometimes if the Company has issued new securities but has not listed its shares, till it is listed there would be mismatch in the valuation of the benchmarked Index with that of the fund.

    5. Rounding off of quantity of shares underlying the index:

    As mentioned earlier an Index Fund has to invest in the securities of the benchmarked Index in the same proportion or weightage of the security as it has in the Index. However, while determining the number of shares that need to be purchased for each security, one would need to round off this number as the minimum number of shares that can be purchased on the exchange is 1.


    The CNX Nifty

    The CNX Nifty is the flagship index on the National Stock Exchange of India Ltd. (NSE). The Index tracks the behavior of a portfolio of blue chip companies, the largest and most liquid Indian securities. It includes 50 of the approximately 1600 companies listed on the NSE, captures approximately 65% of its float-adjusted market capitalization, and is a true reflection of the Indian stock market.

    The CNX Nifty covers 21 sectors of the Indian economy and offers investment managers exposure to the Indian market in one efficient portfolio. The Index has been trading since April 1996, and is well-suited for benchmarking, index funds and index-based derivatives.

    The CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL). IISL is India’s first specialized company focused on an index as a core product.

    Highlights

    The CNX Nifty is a 50 stock, float-adjusted market-capitalization weighted index for India.It is used for a variety of purposes, such as benchmarking fund portfolios, index-based derivatives and index funds.

    The CNX Nifty is derived from economic research and is created for those interested in investing and trading in Indian equities.

    Market Representation. The CNX Nifty stocks represent about 65% of the total float-adjusted market capitalization of the National Stock Exchange (NSE).

    Diversification. The CNX Nifty is a diversified index, accurately reflecting the overall market. The reward-to-risk ratio of CNX Nifty is higher than other leading indices, offering similar returns, but at lesser risk.

    Liquidity. Market impact cost is the best measure of the liquidity of a stock. It accurately reflects the costs faced when actually trading an index. For a stock to qualify for inclusion in the CNX Nifty, it has toreliably have market impact cost below 0.50%, when doing CNX Nifty trades of Rupees (Rs) 2 crores.

    Hedging Effectiveness. The basic risk of the CNX Nifty futures is lower than other index portfolios, due to the liquidity of the CNX Nifty constituent stocks and of the NSE. In addition, the CNX Nifty has higher correlations with typical investment portfolios in India, compared to other indices. These two factors allow for effective hedging of the Index.

    Eligibility Criteria: Selection of the index set is based on the following criteria:

    · Liquidity (Impact Cost)

    · Float-Adjusted Market Capitalization

    · Float

    · Domicile

    · Eligible Securities

    · Other Variables

    Liquidity. For inclusion in the index, the security should have had traded at an average impact cost of 0.50%, or less during the last six months for 90% of the observations.

    Impact cost is the cost of executing a transaction in a security in proportion to its index weight, measured by market capitalization at any point in time. This is the percentage mark-up suffered while buying/selling the desired quantity of a security compared to its ideal price -- (best buy + best sell)/2.

    Float -Adjusted Market Capitalization. Companies eligible for inclusion in the CNX Nifty must have at least twice the float-adjusted market capitalization of the current smallest index constituent.

    Float. Companies eligible for inclusion in the CNX Nifty should have at least 10% of its stock available to investors (float). For this purpose, float is stocks which are not held by the promoters and associated entities (where identifiable) of such companies.

    Domicile. The company must be domiciled in India and should trade on the NSE.

    Eligible Securities. All common shares listed on the NSE (which are of equity and not of a fixed income nature) are eligible for inclusion in the CNX Nifty index. Convertible stock, bonds, warrants, rights, and preferred stock that provide a guaranteed fixed return are not eligible.

    Other Variables .A company which comes out with an IPO is eligible for inclusion in the index if it fulfills the normal eligibility criteria for the index-impact cost, float-adjusted market capitalization and float for a three-month period instead of a six-month period.

    Timing of Changes. The index is reviewed semi-annually, and a four-week notice is given to the market before making any changes to the index constituents.

    Additions. The complete list of eligible securities is compiled based on the float- adjusted market capitalization criteria. After that, the liquidity (impact cost) and float- adjustment filters are applied to them, respectively. The top ranking companies form the replacement pool. The top stocks, in terms of size (float-adjusted market capitalization) are then identified for inclusion in the index from the replacement pool.

    Deletions. Stocks may be deleted due to mergers, acquisitions or spin-offs. Otherwise, as noted above, twice a year a new eligible stock list is drawn up to review against the current constituents. If this new list warrants changes in the existing constituent list, then the smallest existing constituents are dropped in favour of the new additions.



    Index Construction

    Approaches

    The CNX Nifty is computed using a float-adjusted, market capitalization weighted methodology*,wherein the level of the index reflects the total market value of all the stocks in the index relative to a particular base period. The methodology also takes into account constituent changes in the index and corporate actions, such as stock splits and rights issuance without affecting the index value.

    * Beginning June 26, 2009, the CNX Nifty is being computed using float-adjusted market capitalization weighted method, wherein the level of index reflects the float-adjusted market capitalization of all stocks in the Index.

    Index Maintenance

    Rebalancing

    Index maintenance plays a crucial role in ensuring the stability of the index, as well as in meeting its objective of being a consistent benchmark of the Indian equity markets.

    IISL has constituted an Index Policy Committee, which is involved in the policy and guidelines for managing the CNX Nifty. The Index Maintenance Subcommittee makes all decisions on additions and deletions of companies in the index.

    Changes in the index level reflect changes in the market capitalization of the index which are caused by stock price movements in the market. They do not reflect changes in the market capitalization of the index, or of the individual stocks that are caused by corporate actions, such as dividend payments, stock splits, distributions to shareholders, mergers, or acquisitions.

    When a stock is replaced by another stock in the index, the index divisor is adjusted so the change in index market value that results from the addition and deletion does not change the index level.

    Calculation Frequency. The index is calculated real-time on all days that the National Stock Exchange of India is open.

    Corporate Actions and Share Updates

    Maintaining the CNX Nifty index includes monitoring and completing the adjustments for company additions and deletions, share changes, stock splits, stock dividends, and stock price adjustments due to restructurings or spin-offs. Some corporate actions, such as stock splits and stock dividends, require simple changes in the common shares outstanding and the stock prices of the companies in the index.

    Other corporate actions, such as share issuances, change in the market value of an index require a divisor adjustment to prevent the value of the index from changing.

    Adjusting the divisor for a change in market value leaves the value of the index unaffected by the corporate action. This helps keep the value of the index accurate as a barometer of stock market performance, and ensures that the movement of the index does not reflect the corporate actions of the companies in it. Divisor adjustments are made after the close of trading and after the calculation of the closing value of the index. Any change in the index divisor also affects corresponding sub-indices and divisors. Each sub-index is maintained in the same manner as the headline index.

    Corporate actions such as splits, stock dividends, spin-offs, rights offerings, and share changes are applied on the ex-date.

    All singular instances of share changes arising out of additional issue of capital, such as ESOPs, QIPs, ADR/GDR issues, private placements, warrant conversions, and FCCB conversions, which have an impact of 5% or more on the issued share capital of the security, are implemented after providing a five days’ notice period. Share repurchase (buyback) also has the same rules as applicable to share changes.

    Changes entailing less than 5% impact on the issued share capital are accumulated and implemented on a monthly basis.

    Where cumulative share changes exceed 5% of the issued share capital within a month, such changes are implemented after providing five days notice period from the date when such cumulative changes exceeded 5%.

    Currency of Calculation

    For the CNX Nifty, all prices are in Indian rupees.

    Base Date

    The base period for the CNX Nifty index is November 3, 1995, which marked the completion of one year of operations of NSE's Capital Market Segment. The base value of the index has been set at 1000, and the base capital at Rs 2.06 trillion.

    Index Data

    Total Return

    The CNX Nifty reflects the return one would get if an investment is made in the index portfolio. As the CNX Nifty is computed in real- time, it takes into account only the stock price movements. However, the price indices do not consider the return from dividend payments of index constituent stocks. Only the capital gains and losses due to price movement are measured by the price index. In order to get a true picture of returns, the dividends received from the index constituent stocks also need to be included in the index movement. Such an index, which includes the dividends received, is called the total return index.

    The total return index reflects the returns on the index from stock prices fluctuation plus dividend payments by constituent index stocks.

    Hedging Effectiveness

    The CNX Nifty has been tested against numerous randomly chosen, equally-weighted portfolios of different sizes, varying from 1 to 100 small, mid and large cap companies, as well as many industry indices/sub-indices provided by CMIE for hedging effectiveness.

    Using monthly returns data, it was observed that the correlation (R2) for various portfolios and indices on the CNX Nifty was significantly higher than other benchmark indices, indicating that the CNX Nifty had higher hedging effectiveness.

    Trading in derivative contracts based on CNX Nifty

    The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with index futures on June 12, 2000. The futures contracts on the NSE are based on the CNX Nifty. The exchange introduced trading on index options based on the CNX Nifty on June 4, 2001.

    Index Governance

    Index Committee

    A professional team at IISL manages the CNX Nifty. There is a three-tier governance structure comprising the board of directors of IISL, the Index Policy Committee, and the Index Maintenance Subcommittee. IISL has constituted the Index Policy Committee, which is involved in the policy and guidelines for managing the CNX Nifty. The Index Maintenance Sub-committee makes all decisions on additions and deletions of companies in the Index. The CNX Nifty has fully articulated and professionally implemented rules governing index revisions, corporate actions, etc. These rules are carefully considered, using Indian market conditions, to dovetail with operational problems of index funds and index arbitrageurs.

    Index Policy

    The CNX Nifty uses transparent, researched and publicly documented rules for index maintenance. These rules are applied regularly to manage changes to the index. Index reviews are carried out semi annually to ensure that each security in the index fulfills eligibility criteria.

    Announcements

    All index-related announcements are posted on the NSE website. Changes impacting the constituent list are also posted on the website.

    Please refer to the NSE website at www.nseindia.com

    Holiday Schedule

    For the calculation of indices, the IISL follows the official holiday schedule.

    A complete holiday schedule for the year is available on the NSE website. Please refer to the NSE Web site at www.nseindia.com

    Real-Time Calculation

    The indices are calculated real-time whenever there is a change in price.

    · A security is traded in full accordance with the present methodology.

    · The best bid price of a security exceeds the last calculated price of the security.

    · The best ask-price of a security is less than the last calculated price of the security.

    Index Precision

    The level of precision for index calculation is as follows:

    · Index values are published rounded to two decimal places.

    · Share prices are rounded to two decimal places.

    · Shares outstanding are expressed in units.

    · Float-adjusted market capitalization is stated to two decimal places.

    · Index values are calculated to two decimal places.

    · Final settlement prices are published rounded to two decimal places.

    Index Dissemination

    Tickers

    Index

    Bloomberg

    Reuters

    CNX Nifty

    NIFTY

    .NSEI

    Web site

    Daily index values, index constituents, methodology, and special announcements are available on the NSE Web site at www.nseindia.com

    Appendix

    Price Index Calculations Formula

    The CNX Nifty is computed using market capitalisation weighted method wherein the level of the Index reflects the total market value of all the stocks in the Index relative to the base period November 3,1995. The total market cap of a company or the market capitalisation is the product of market price and the total number of outstanding shares of the company.

    Market Capitalization = Equity Capital * Price

    Free Float Market Capitalization = Equity Capital * Price * IWF

    Index Value = Current Market Value / Base Market Capital * Base Index Value (1000)

    Base market capital of the Index is the aggregate market capitalisation of each scrip in the Index during the base period. The market cap during the base period is equated to an Index value of 1000 known as the base Index value.

    Total Return Index Calculation Formula

    The total return version of the index is also available, which assumes dividends are reinvested in the index after the close on the ex-date.Corporate actions like dividend announcement do not require any adjustment in the normal price index (other than a special dividend).

    A separate Total Returns Index (TR) is calculated which shows the returns on Index portfolio, inclusive of dividends.

    Calculation of the TR Index:

    TR Index = [Prev. TR Index + (Prev. TR Index * Index returns)] + [Indexed dividends + (Indexed dividends * Index returns)]

    Index dividend for the day‘t’ = Total Dividends of the scrips in the Index/Index divisor for the day

    Total dividends of scrips in the Index =

    Rights Equity Issue

    Rights offer:

    In rights offer a company comes up with a new issue available only to the existing shareholders. The company invites more funds from its existing shareholders. The price per share for additional equity, called the subscription price, is left to the discretion of the company. It results in capital inflow and increase in the share capital of the company. Rights issue results in increase of the market capitalisation of the company, thus needs to be adjusted in the Index.

    Action :

    Step 1 :Find out the ratio in which the rights issue is made, i.e., for how many shares held in the company will one rights share be issued.

    Step 2 :Find out the offer price of the rights issue by the company.

    Step 3 :Calculate the additional market cap due to rights issue (additional rights shares * rights price).

    Step 4 :Add it to the existing market cap of the Index.

    Step 5 :Calculate the new base capital of the Index after the rights issue as per the formula given below:


    Calculation of change in the base capital

    Revised base capital = New market Cap/Index value * 1000

    New Market Cap = ( N * P ) + Old Market Cap of the Index

    N = number of new shares offered under rights issue
    P = offer price

    Old market cap is the closing market cap of the Index before the adjustment is made.

    Changes would be made on the ex-date set by the exchange (NSE). All changes would be made before the commencement of the normal market. After the market opens, all subsequent Index values will be calculated with respect to the revised base capitalization

    The above changes are made on the assumption that the rights issue is fully subscribed. In the case of the rights issue not being fully subscribed, the share capital of the company will be adjusted based on the subscription received. This would be done once the company intimates the exchange.

    Bonus Issue & Share Splits

    Bonus issue: Bonus issues are shares issued to existing shareholders as a result of capitalization of reserves. It increases the number of outstanding shares of the company. Bonus event does not require any adjustment to the Index as the increase in number of shares is accompanied by a fall in the share price in the same ratio, hence, it has no theoretical effect on market capitalisation.

    Action :

    Step 1 :

    Find out the ratio in which the bonus issue is made, i.e., for how many shares held in the company will one bonus share be issued.,

    Step 2 :

    Increase the number of outstanding shares of the company as a result of bonus issue.

    Share Splits: Share Splits is the change in face value of a stock. In a share split the par value per share is reduced and the number of shares is increased proportionately resulting in no change in the share capital of the company.

    The treatment is similar to that of a bonus issue. Changes will be made in the ratio set by the company on the ex-date set by NSE. All changes would be made before the commencement of the normal market.

    Debt Conversion, Warrant Conversion / Public Issue (Domestic/Foreign), Private Placement, Forfeiture

    Debt conversion: When a company issues fully or partly convertible debentures, these debentures can be converted partially or fully into equity shares during a certain period.

    Warrant conversion: A warrant provides its holders with the option to subscribe to the equity shares of the company during a certain period at a price specified by the company. Warrants are normally issued as an incentive along debt issue and the holder is given the right to subscribe equity shares.

    Private Placement: A Private Placement results in a company’s sale of shares to one or few investors. All these corporate actions like Debt conversion, Warrant conversion, Public issue, preferential allotment and Private placement lead to an increase in the share capital of the company.

    Action :

    Step 1 :ind out the number of shares arrived for listing on the NSE Issue as a result of Debt conversion or Warrant conversion.

    Step 2 :Find out the market prices of the shares before the adjustment is made.

    Step 3 :Compute the increase in current market cap due to the above corporate action.

    Step 4 :Compute the new base capital as per the formula given below.

    Note: The size of the share capital of the company will be changed on the date of listing of the additional shares on the National Stock Exchange (NSE). It is carried out before the commencement of the normal market. After the market opens all subsequent Index values will be calculated with respect to the revised base capitalisation.

    Calculation of revised base capital

    Revised base capital = New market Cap/Index value* 1000

    New Market Cap = ( N * P ) + Old Market Cap
    N = number of new shares offered
    P = previous closing price

    Old market cap is the closing market cap of the Index before the adjustment is made.

    Forfeiture of Shares:

    The company has the right to forfeit the shares incase the shareholder defaults on call money and for other reasons also. If the shares are forfeited, then the number of outstanding shares of the company comes down resulting in a decline of the market cap of the company. The base capital adjustment would be made once the exchange receives information about the delisting of shares.

    Mergers and Acquisition

    It refers to the combination of two or more companies into one. The shareholders of the merged entity get shares in the acquiring company. It results in the change of the capital structure of the acquiring company. The merged company becomes a non-existing entity.

    We have following cases:


    1. Merger of any listed company with an Index company
    In this case the acquiring company is an Index company and the merged company is any Non-Index, listed company on the stock exchange.

    Action :

    Step 1 : Find out the agreed ratio for the merger, i.e., for how many shares of the merged company will one share of the acquiring company be issued.

    Step 2 :Compute the number of additional shares being issued of the acquiring company under the merger.

    Step 3 :Compute the increase in current market cap due to the issue of new shares.

    Step 4 :

    Compute the new base capital in the same way as done for debt conversion., explained above

    The adjustment in the share capital of the acquiring company and the base capital in the Index will be made on the delisting/ex-date of the merging entity. After the market opens all subsequent Index values will be calculated with respect to the revised base capitalisation

    2. Merger of an unlisted company with an Index company

    In this case the company in the Index acquires another company which is not listed on the stock exchange.

    Action:

    Additional shares of the acquiring company would be issued to the shareholders of the merging entity. These additional shares would be added to the existing share capital of the acquiring company on the listing date of these shares.

    Step 1 :

    Find out the number of additional shares being issued by the acquiring company under the merger.

    Step 2 :

    Compute the increase in current market cap due to the issue of new shares

    Step 3 :

    Compute the new base capital in the same way as done for debt conversion, explained above.

    3. Merger of two Index companies

    In this case both the acquiring as well as the merging company is Index company. In other words two of the Index companies will merge into a single company, thus requiring the Index to be added with one more company.

    Action :

    Step 1 :

    Find out the merger ratio and thus the number of shares issued by the acquiring company to the shareholders of the merged company.

    Step 2 :

    Compute the increase in the market cap of the acquiring company as a result of merger.

    Step 3 :

    Compute the net addition or deletion in the market cap of the Index as a result of the merger according to the formula given below.

    Step 4 :

    Compute the new base-market cap of the Index according to the formula given below.

    One more important step after the court approves the merger of the two companies in addition to the above is to find a replacement for the company which is getting merged. After the merger it would become a non- existing entity and hence would be removed from the Index. The new company will be selected according to the set criteria of replacement for that Index. The selected company will be included in the Index giving prior intimation of 5 weeks through a press release. All changes are made before the commencement of normal market.

    Calculation of revised base capital

    Revised Base capital = New market cap/Index value* 1000
    New market cap = ( NAD ) + Old market cap of the Index

    NAD = Net addition / deletion of the market cap

    NAD = (Increase in market capital of company post merger )
    – ( Market Capital of the merged company )

    Old market cap is the closing market cap of the Index before the adjustment is made.

    The NAD can also be negative if the market cap of new shares offered is less than the value of the market capital of the merged company.

    After this there is another adjustment required regarding the inclusion of the new company in the Index as the merged company becomes a non-existing entity.

    4. Merger of an Index company with a company outside the Index
    In this case an Index merges with a company which is not in the Index. Here the acquiring company is the company outside the Index and the merging entity is the company within the Index. Henceforth, after the merger the Index Company would become a non-existing entity. In this case an adjustment would need to be made on account of the removal of the merging entity and its replacement with a new company.

    Action : A replacement would be found for the Index company using the set selection guidelines. The selected company will be included in the Index and the merging entity removed giving prior intimation of 5 weeks through a press release. All changes will be made before the commencement of the normal market.

    Addition / Deletion from the Index Set

    The composition of an Index can change from time to time due to various factors, such as merger /acquisition, bankruptcy, restructuring, lack of representation and not fulfilling Index selection criteria.

    Each Index has a Replacement Pool comprising companies that meet all criteria for candidacy to that Index. All replacements of companies in the Index take place from this pool.

    Action :

    Step 1 :

    Compute the market capitalisation of the companies being deleted from the Index with the closing market prices before the adjustment is made.

    Step 2 :

    Similarly compute the market cap of the companies being included in the Index

    Step 3 :

    Compute the net change to the total market cap of the Index by deducting the market cap of the companies deleted from the market cap of the companies added.

    Step 4 :

    Compute the new base capital of the Index.

    The companies to be added and deleted from the Index would be informed through a press release 5 weeks in advance. The changes would be carried out before the commencement of normal market on Wednesday. After the market opens all subsequent Index values will be calculated with respect to the revised base capitalisation and revised constituents.

    Calculation of revised base capital

    Revised Base capital = New market cap/Index value* 1000
    New market cap = Net change + Old market cap of the Index

    Net change = (Market capital of companies added to the Index )
    - ( Market Capital of the companies deleted from the Index )

    Old market cap is the closing market cap of the Index before the adjustment is made

    Dividend announcement

    Corporate actions like dividend announcement do not require any adjustment in the normal price Index. A separate Total Returns Index (TR) is calculated which shows the returns on Index portfolio, inclusive of dividends. The Total Returns Index is always calculated on an existing market capitalisation Index.

    Action :

    Step 1 :

    Find out the dividend per share declared by the company.

    Step 2 :

    Find out the outstanding number of shares of the company.

    Step 3 :

    Compute the total amount of dividend payable by the company. It is the product of dividend per share and the outstanding number of shares of the company.

    Step 4 :

    Compute the Index dividend for the day as per the formula given below.

    Step 5 :

    Compute the new TR Index according to the formula given below.

    Changes to the Total Returns Index will only be done in the case of a dividend event. Dividend events will be accounted for on the ex-date as decided by the NSE.

    Calculation of the TR Index

    TR Index = Old TR Index value * ( MC Index value ) + ( Index dividend for the day )
    --------------------------------------------------
    Old MC Index value

    Total Dividends of the scrips in the Index
    Index dividend for the day = -------------------------------------------
    Index divisor of the MC Index

    MC Index = Market cap based Index for which the Total returns Index is calculated

    Total dividends of scrips in the Index = Dividend per share * shares outstanding

    Adjusting Index funds for corporate actions

    Rights issue

    The Index fund needs to adjust the weightages of its portfolio due to a rights event.

    The Index fund needs to adjust the weightages of its portfolio due to a rights event.

    Every fund maintains some portion of its portfolio in cash to meet liquidity, hence it can be used to subscribe the rights issue.

    The fund can let the rights issue expire and rebalance its portfolio on the ex-date.

    Bonus Issue

    In bonus issue theoretically there is no change in the market cap of the underlying security, therefore it does not require any adjustment at the base capital level. Since no adjustment is made to the base capital of the reference Index, there is no adjustment required to be made in the Index fund.

    Debt conversion / Warrant conversion / Public Issue / Private Placement

    A Debt / Warrant / Public Issue / Private Placement conversion leads to an increase of the weightage of the security in the Index. Thus, the Index fund will have to increase the weightage of that security in its portfolio. It would need to do this by purchasing extra shares from the open market on the date the adjustment is made to the Index. The cash for this purchase can be generated either by selling off securities from the existing basket of stocks or from the cash buffer.

    Mergers and Acquisition

    The different possibilities of mergers and acquisitions are as follows:

    1)

    Merger of any listed company with an Index company: As shares of the acquiring company will be issued to the shareholders of the merging entity, the market cap of the acquiring entity would increase leading to an increase in its weightage in the Index. In this case the only adjustment required would be to increase the weightages of the acquiring company. Therefore, shares have to be purchased to rebalance the fund weightages on the ex-date when the adjustment in the Index were made. The cash for this purchase can be generated either by selling off securities from the existing basket of stocks or from the cash buffer.

    2)

    Merger of any unlisted company with an Index company: The adjustment has to be the same as in the case given above. Shares of the acquiring company has to be purchased to the extent the weightage in the Index increases due to a change in the number of outstanding shares.

    3)

    Merger of two Index companies: In this case, two adjustments take place

    a)

    The market cap of the acquiring company will increase : This might not be an issue of concern as the fund would automatically get shares in the acquiring company for their holdings in the merging company.

    b)

    A new company would be included in the Index : The fund should be rebalanced by selling off a part of all the stocks in the Index in order to generate enough cash to buy the new stock that is entering the Index.

    4)

    Merger of an Index company with a company outside the Index : In this case the adjustment in the portfolio is to sell off the entire shares of the merging Index company and buy the shares of the new Index company according to its new weightage. The fund may even need to sell a part of its existing portfolio in order to generate enough cash to buy shares of the new company in case of a difference of the market caps of the two companies.

    Addition and Deletion of companies in the Index: The fund needs to sell the shares of the company being removed from the Index. In case if the market cap of the incoming company is greater than that of the outgoing company, a portion of all the other securities in the Index has to be sold to buy the incoming stock


    Cash dividends : Cash dividends require prompt reinvestment unless they are directly passed on to the investors. A simple alternative is to accumulate cash dividends in a short-term investment fund. At the end of a specified period the fund manager can move the funds into the stock markets

    Practical problems faced in managing Index funds

    On the face of it, though Index funds are passively managed funds, there are a number of practical problems to be faced in running an Index fund which have an impact on the tracking error.

    They are as follows:-

    1.

    An Index fund is not fully invested at all times. It needs to maintain a sufficient cash buffer in order to meet its liquidity requirements. As a result the returns on this money held for liquidity purpose would differ from the returns on the Index.

    2.

    Fund may not be able to obtain new issues at the price at which they are included in the Index.

    3.

    An Index fund may find difficulties in adjusting its portfolio, if certain securities are in the no delivery period.

    4.

    Adjustments to the Index for corporate actions, such as rights issue, bonus issue, cash dividends are made on the ex-date but the fund gets the actual shares or the dividend amount only after a certain period. Till then, it will continue to have an impact on the tracking error.

    Maintaining liquidity and cash flows

    It is impossible for an Index fund to be 100% invested in stocks at all times. Some portion of the portfolio must be kept in cash for redemption purposes. A number of techniques may be used to handle the flow of cash into an Index fund. There are different ways in which cash flow may be invested into an Index fund:

    1.

    By use of Index futures

    Index fund managers in order to keep their funds fully invested can use futures contracts. Index futures are contractual agreements to buy or sell the Index at a specific date in the future but at a price fixed today. The asset allocated to futures contract will obtain the same rate of return as the Index and entry in and out of the futures market can be made at a very low cost.

    Cash derived from dividend income and other inflows can be used to invest in futures contracts for a short period till reinvestment is made in the stocks. When the cash reaches a size that is sufficient to invest the futures positions can be closed and the funds can be invested in physical assets.

    2.

    By temporarily investing into fixed income securities

    The cash can be invested in short-term money market instruments carrying fixed income or in the call money markets. Thus, the cash held for liquidity purpose can be used to generate returns to reduce the risk of the fund being hit on the tracking error.

    Measuring the performance of Index funds

    Index funds are designed to produce returns in line with the predefined Index. The returns of an index fund as measured by its NAV, should be compared with the Total Returns Index. The reason being, Index funds reinvest their dividends and the Total Returns Index shows the returns on Index portfolio inclusive of dividends.

    Other related concepts

    Synthetic Index funds : Index funds can be created both on physical assets as well as on derived instruments like stock Index futures. Funds based upon derivative instruments are called Synthetic Index funds and they try to give the same returns as the Index without any need to hold the underlying securities. Synthetic Index funds offer a low transaction cost than the normal Index funds, provided the Index futures markets are liquid. They do not require any adjustment for any corporate actions or any changes in the Index constituents. On the negative side they are deprived of the benefits of stock lending and cash dividends distributed by the company.

    Secondly the Index future contracts expire, and the Index fund would need to re-establish this position on the next available contract, a process called rollover. Large Index funds would suffer considerable transaction cost when doing the rollover and if the markets are not adequately liquid it would not support such large transactions.

    Stock lending : Stock lending is a mechanism whereby an investor requiring a particular security borrows it from the holder of the security in return for a fee. Index funds are ideal for stock lending programs as they hold long-term assets.

    Tilted Funds: It is constructed with a portfolio similar to the Index but with a bias towards a certain factor. The aim of such a fund is to outperform the Index on a consistent basis. It may be biased towards factors like high yield stocks, sector specific stocks, stocks with higher correlation, etc. Some funds abroad offer a tilt rotational approach i.e. different factors may govern the investment philosophy of the fund at different points of time depending on market condition.

    Potential in India

    Pension funds

    The use of Index funds found its early support from the pension funds in the US markets. The growth of Index funds in the US and UK markets have been largely due to the investments of pension funds. In the Indian context, it is likely that the government will liberalise the pension fund sector in the coming years, to allow them to invest in the equity markets. However, most of these investments are likely to flow into the equity market through the Index fund route. Further, with banks now allowed to invest a portion of their assets in the equity markets, Index funds may be a good avenue for such investments.

    SEBI Guidelines for Index funds

    The guidelines for Index funds are the same as applicable to mutual funds in India with the following one exception.

    The investments by index funds shall be in accordance with the weightage of the scrips in the specific index as disclosed in the offer document. In case of sector/industry specific scheme, the upper ceiling on investments may be in accordance with the weightage of the scrips in the representative sectoral index/sub index as disclosed in the offer document or 10% of the NAV of the scheme whichever is higher.

    Information Courtesy : www.nseindia.com



 

Important Links