|
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
-
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.
-
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.
-
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.
-
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.
-
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
|
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 Vs Non Index funds
|
|
Index
funds
|
Non
Index funds
|
|
1.
|
The
objective of
the fund is to
mimic the
target Index.
|
The
objective of
the fund is to
beat a
specified
Index.
|
|
2.
|
It
is known as
passively
managed funds.
The process of
management of
an Index fund
does not
involve any
fundamental
research. It
is a fund with
a very low
level of
trading.
|
It
is known as
actively
managed funds.
The process of
management of
Non-Index
funds involves
fundamental
research and
quantitative
analysis to
identify
securities,
which are to
be bought and
sold in order
to fulfill the
objective.
|
|
3.
|
It
requires
expertise in
determining
the target
Index and in
designing the
Index fund to
meet the
characteristics
of the chosen
Index.
|
It
requires
superior
forecasting
skills to
determine when
and which
security to
buy and sell.
|
|
4.
|
Investors
in Index funds
are committed
to a low risk
profile. Since
the Indexes
have
diversified
portfolios and
the stocks in
the Index fund
are held in
the same
proportion as
in the Index,
it is less
prone to risk.
|
The
portfolio of a
Non-Index fund
is subjective
and the
portfolio
changes
according to
the fund
manager’s
decision. Here
the success of
the portfolio
totally
depends on the
fund
manager’s
ability.
|
|
5.
|
The
job of an
Index fund
manager is to
track the
Index as
closely as
possible. They
should make
timely
adjustments in
the portfolio
to match the
Index.
|
The
Non Index fund
manager's job
is to pick
stocks that he
believes will
do well with
the implicit
goal of doing
better than a
comparable
Index.
|
|
6.
|
The
expense ratio
of an Index
fund is low.
As the Index
fund follows
the buy and
hold strategy,
the turnover
of stocks are
less leading
to minimal
transaction
cost.
|
The
expense ratio
is high in
this case. The
portfolio is
often churned
depending on
the markets
resulting in a
high turnover
and
transaction
cost.
|
|
7.
|
The
returns on the
fund depend on
the
performance of
the whole
equity
markets.
|
The
returns on the
funds depend
on the
performance of
the fund
managers.
|
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: It refers to the 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, 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 annualised tracking error as per the formula given
below
|
| |
Annualised tracking error = Standard deviation obtained (Step 4) * sqrt
(250) |
| |
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.
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 reinvests promptly.
Calculation Methodology of the S&P CNX Nifty
The S&P 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 Capitalisation = Outstanding Equity Capital * Price
In this method the weightages are not fixed, they change with the stock price
movements and changes in the number of shares outstanding. All selected
securities in the Nifty bear a weight in the proportion of their market
capitalisation.
General Index formula calculation
Base Capitalisation Method
Current market capital
Index
value =
------------------------
* Base Index Value (1000)
Base market capital
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.
Current market capital of the Index is the aggregate market capitalisation of
each scrip in the Index during the current period. The current price of each
stock is multiplied by the number of shares outstanding to give the aggregate
current market cap of the Index.
At any given time , the Index level is equal to the total current market value of
the portfolio, divided by the base period market value , multiplied by base Index
value. A Nifty Index level of 1500 will indicate that the aggregate price of the
portfolio has risen by 50% over the base period.
Maintaining an Index fund
An Index fund should track the weightages of the securities in the Index.
Weightages of the securities in the Index fund would need to be rebalanced due to
the following two reasons :-
1. Corporate Actions and change in Index set.
2. Inflows or Outflows for the fund
First we will see how the adjustments are made in the Index for Corporate actions
and later on we will examine how an Index fund should be rebalanced.
Corporate Actions
The current market cap of a company is the product of number of shares
outstanding and the current market price. The market cap of the company changes
if there is either a change in the
•
Price (or)
•
number of shares outstanding changes
However, equity Index should reflect changes in the market cap of its companies
only due to a change in prices of the scrips and not due to changes in the number
of outstanding shares of the companies. Therefore any corporate action leading to
a change in the market cap of the company due to a change in the number of shares
outstanding requires an adjustment in the Index Base capital / Divisor. The Index
is adjusted in a manner, which keeps the Index value constant. Any corporate
action would lead to a change in the weightage of the stock in the Index.
Corporate Actions such as rights issue, mergers & acquisitions, debt conversion,
etc. result in a change in the number of outstanding shares of the company. The
market cap method allows adjustment for such corporate actions without affecting
the continuity of the Index. When such actions are initiated in an Index
security, their effect will reflect through a change in the Index divisor / base
capitalisation required for Index computation. By adjusting the Index divisor /
base capitalisation for a change in market value, the value of the Index remains
constant.
| IISL will carry out the following changes to its Indexes: - |
|
|
The base market capitalisation / divisor of the Index will be revised to adjust for the change in the outstanding shares due
to a corporate action. |
|
|
The revision of the base capitalisation / divisor will be done off-line and before the commencement of the normal market. |
|
|
Subsequent Index values will be calculated using the revised base capitalisation or revised divisor. |
Types of Corporate Actions
|
Sr. No.
|
Type of
corporate
action
|
Base
Capitalisation
/
Divisor
Adjustment
|
5 / 6
in
Base
Capitalisation
/
Divisor
|
|
1
|
Rights
|
Yes
|
5
|
|
2
|
Bonus
|
No
|
1
|
|
3
|
Share
splits
|
No
|
1
|
|
4
|
Debt
conversion
|
Yes
|
5
|
|
5
|
Warrant
Conversion
|
Yes
|
5
|
|
6
|
Public
Issue
(Domestic)
|
Yes
|
5
|
|
7
|
Public
Issue
(Foreign-GDR/ADR)
|
Yes
|
5
|
|
8
|
Forfeiture
of shares
|
Yes
|
6
|
|
9
|
Corporate
restructuring
|
Yes
|
5 / 6
|
|
10
|
Mergers and
Amalgamations
|
Yes
|
5 / 6
|
Events other than corporate actions that have an impact on the Index are: -
|
Sr. No.
|
Type of
corporate
action
|
Base
Capitalisation
/Divisor
Adjustment
|
5 / 6
in
Base
Capitalisation
/Divisor
|
|
1
|
Addition /
Deletion of
Index
companies
|
Yes
|
5 / 6
|
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
New market Cap
Revised base capital
=
------------------
* 1000
Index value
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 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.
Consider the event of rights issue by ACC in the ratio 1:4 ( 1 right share for every 4 shares held in the company ) at an offer price of Rs.55
Ex date 19 may 2009
|
Market Cap
of S&P
CNX Nifty on
May 18, 2009
|
Rs. 2,553.6
bn
|
|
Closing
Index Value of
S&P CNX
Nifty on
May 18, 2009
|
1,160.15
|
|
Existing
number of
Equity shares
of ACC
|
137,012,320
|
|
Price of
ACC on May 18,
2009
|
Rs. 181.45
|
|
Market Cap
of ACC on May
18, 2009
(137,012,320 *
181.45)
|
Rs. 24.9 bn
|
|
Additional
shares of ACC
due to Rights
( 137,012,320
/ 4)
|
34,253,080
|
|
Rights
Price
|
Rs. 55
|
|
Market Cap
of shares
added (
34,253,080 *
55)
|
Rs. 1.9 bn
|
|
New Market
Cap of ACC (
24.9 bn + 1.9
bn)
|
Rs. 26.8 bn
|
|
Theoretical
Price ( 26.8
bn /
171,265,400)
|
Rs. 156.16
|
|
New Market
Cap of S&P
CNX Nifty (2553.6bn+
1.9bn)
|
Rs. 2,555.5
bn
|
|
Old Base
Cap of Index (
old market cap
* 1000 / Index
value )
|
Rs. 2,201
bn
|
|
New Base
Cap of Index (
new market cap
* 1000 / Index
value)
|
Rs.
2,202.7 bn
|
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 do 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 having no theoretical effect on its 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.
Consider the event of NIIT coming up with a bonus issue of 1:2 ( one bonus share for every two shares held ) on ex date March
3, 2009
|
Market Cap
of S&P
CNX Nifty on
Mar 02, 2009
|
Rs. 2,227
bn
|
|
Closing
Index Value of
S&P CNX
Nifty on
Mar 02, 2009
|
1,015.80
|
|
Number of
existing
equity shares
of NIIT
|
25,768,086
|
|
Price of
NIIT on Mar
02, 2009
|
Rs.
2,862.00
|
|
Market Cap
of NIIT on Mar
02, 1999
(25,786,086 *
2,862)
|
Rs. 73.75
bn
|
|
No of
shares added
on account of
bonus(25,786,086
/ 2)
|
12,884,043
|
|
Total
number of
shares of NIIT
after bonus
issue
(25,768,086
+,12,884,043)
|
38,652,129
|
|
Theoretical
Ex-Bonus Price
of NIIT( 2,862
* 2/3)
|
Rs.
1,908.00
|
|
New Market
Cap of NIIT (
38652129 *
1,908 )
|
Rs. 73.75
bn
|
Since there is no change in the market capital of NIIT, no adjustment in the base capital will be required.
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 in the increase in the share capital of the company.
Action :
|
|
Step 1 : |
Find 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
New market Cap
Revised base capital
= -------------------
* 1000
Index
value
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. |
Consider the event of debenture conversion by Reliance Petroleum into 236,462,800 shares on Sep 23, 2009.
|
Market Cap
of S&P
CNX Nifty on
Sep 22, 2009
|
Rs. 1,852.2
bn
|
|
Closing
Index Value of
S&P CNX
Nifty on
Sep 22, 2009
|
897.25
|
|
No of
shares offered
for conversion
|
236,462,800
|
|
Share Price
of Rel Petro
on Sep 22,
2009
|
Rs. 17.80
|
|
Current
equity shares
of Rel Petro
|
903,156,100
|
|
Total O/S
Equity shares
of Rel Petro
after
conversion
(903,156,100 +
236,462,800 )
|
1,139,618,900
|
|
Additional
Market Cap of
Rel Petro
(236,462,800 *
17.80 )
|
Rs. 4.2 bn
|
|
New Market
Cap of Rel
Petro
(1,139,618,900
* 17.80 )
|
Rs. 20.3 bn
|
|
New Market
Cap of S&P
CNX Nifty
(1,852.2 +
4.2)
|
Rs. 1,856.4
bn
|
|
Old Base
Cap of S&P
CNX Nifty
(1,852.2 *
1,000 /
897.25)
|
Rs. 2,064
bn
|
|
New Base
Cap of S&P
CNX Nifty
(1,856.4
bn * 1,000 /
897.25 )
|
Rs.
2,069 bn
|
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 shares outstanding 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 Acquisitions
It is 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 the 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 Index company
In this case a 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 and the merging companies are Index companies. 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
New market cap
Revised Base capital
=
--------------------
* 1000
Index value
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. This adjustment is explained under the head Addition and deletion of companies in the Index.
Consider the event of Ponds merger with HLL on Jan 20, 2009 . The Merger Ratio being 3 Equity shares of HLL for 4 Equity shares held in Ponds.
|
Market Cap
of S&P
CNX Nifty on
Jan 19, 2009
|
Rs. 1,990
bn
|
|
Closing
Index Value of
S&P CNX
Nifty on
Jan 19, 2009
|
924.10
|
|
Market Cap
of Ponds on
Jan 19, 2009
|
Rs. 37.1 bn
|
|
Existing
Equity shares
of HLL
|
199,167,287
|
|
Price of
HLL on Jan 19,
2009
|
Rs.
1,704.20
|
|
Market Cap
of HLL on Jan
19, 2009
(199,167,287 *
1,704.20 )
|
Rs. 339.4
bn
|
|
Addition to
O/S Equity Cap
of HLL on
account of
merger with
Ponds
|
20,402,209
|
|
Additional
Market Cap of
HLL on account
of merger with
Ponds (
20,402,209 *
1,704.20 )
|
Rs. 34.8 bn
|
|
New Market
Cap of HLL (
339.4 + 34.8 )
|
Rs. 374.2
bn
|
|
Net
Addition/Deletion
of Market Cap
to Index on
account of
merger (Rs.
34.8 bn – Rs.
37.1 bn )
|
(Rs. 2.3 bn
)
|
|
New Market
Cap of S&P
CNX Nifty(
Rs.1,990 bn +
( Rs. 2.3 bn))
|
Rs. 1,987.7
bn
|
|
Old Base
Capital of S&P
CNX Nifty
|
Rs. 2,153.5
bn
|
|
New Base
Capital of S&P
CNX Nifty (1,987.7
* 1000 /
924.10 )
|
Rs.
2,151 bn
|
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 or removal of the merging entity and 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,
not fulfilling Index selection criteria, etc.
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
New market cap
Revised Base
capital =
-------------------
* 1000
Index value
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 |
Consider the event
when seven
securities were
added and deleted
to the S&P CNX
Nifty on Oct 07,
1998
|
Companies
Added
|
Market
Cap on Oct 06,
1998
|
|
1. Infosys
Technologies
LTD
|
Rs. 36.2 bn
|
|
2. NIIT
Ltd.
|
Rs. 33.4 bn
|
|
3. Bank of
India
|
Rs. 15.8 bn
|
|
4.
Smithkline
Beecham
Consumer
Healthcare
|
Rs. 21.6 bn
|
|
5. Hero
Honda Motors
Ltd.
|
Rs. 23.5 bn
|
|
6. Procter
& Gamble
Ltd.
|
Rs. 16 bn
|
|
7. Cipla
Ltd.
|
Rs. 15.9 bn
|
|
Total
|
Rs.
162.4 bn
|
|
Companies
Deleted
|
Market
Cap on Oct 06,
1998
|
|
1.BPCL
|
Rs. 33.8 bn
|
|
2.Ashok
Leyland LTD
|
Rs. 2.7 bn
|
|
3.
Indo
Gulf
Fertilisers
|
Rs. 5.8 bn
|
|
4.Andhra
Valley Power
Supply LTD
|
Rs. 4.6 bn
|
|
5.Thermax
LTD
|
Rs. 3.8 bn
|
|
6.MRPL
|
Rs. 5.4 bn
|
|
7.Ponds
India LTD
|
Rs. 35.3 bn
|
|
Total
|
Rs. 91.4
bn
|
|
Market Cap
of S&P
CNX Nifty on
Oct 06, 1998
|
Rs. 1,750
bn
|
|
Closing
Index Value of
S&P CNX
Nifty on
Oct 06, 1998
|
845.75
|
|
Net
Addition /
Deletion of
Market Cap to S&P
CNX Nifty on
account of
Addition /
Deletion of
constituents (
Rs. 162.4 bn
– Rs. 91.4
bn )
|
Rs.71 bn
|
|
New Market
Cap of S&P
CNX Nifty on
account of
Addition /
Deletion. (Rs.
1750 bn + Rs.
71 bn )
|
Rs. 1,821
bn
|
|
Base Market
Cap of S&P
CNX Nifty
|
Rs. 2,069
bn
|
|
New Base
Market Cap of S&P
CNX Nifty
(Rs. 2069
bn * 1000 /
845.75 )
|
Rs. 2,446
bn
|
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 |
Consider the event of Dividend declaration by two companies included in the Nifty
Index on March 08, 2000.
1. Hindustan Lever Limited declared a final dividend of Rs. 17 per share
2.
Glaxo India Limited declared a dividend of Rs. 6 per share
Calculation of Total Returns Index for March 08, 2000
Nifty is the market cap based Index on which the TR Index is calculated
|
Closing Nifty
Index value
on March
08,2000
|
1666.35
|
|
Closing Nifty
Index value
on March
07,2000
|
1702.75
|
|
Closing TR
Index value
on March
07,2000
|
1806.31
|
|
Nifty Index
Divisor
|
2,427,483,702
|
|
Number of
outstanding
equity shares
of HLL
|
219,569,495
|
|
Total
dividends
payable by HLL
( 219,569,495
* 17 )
|
Rs. 3.73 bn
|
|
Number of
outstanding
equity shares
of Glaxo
|
59,775,000
|
|
Total
dividends
payable by
Glaxo (
59,775,000 * 6
)
|
Rs. 359 mn
|
|
Index
Dividend (
(Rs.3.73
bn + Rs. 359
mn ) /
2,427,483,702 )
|
1.68542
|
|
New TR
Index value (1806.31
*
(1666.35+1.68542))
---------------------------
1702.75
|
1769.48
|
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 to the base
capital. Since no adjustment is made to the base capital of the reference Index,
there is no adjustment required to 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 Acquisitions
The different possibilities of mergers and acquisitions are
|
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 is 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 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 there are two adjustments
taking 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 cap[s 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 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 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 it difficult to adjustment 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
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 (as explained on Page 25). 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 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 normal Index funds
provided the Index future 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 log-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.
The markets abroad
Index funds became well established in the United States at the end of 1970’s. It
is observed that more than 25% of the domestic equities in the US are held by
institutional investors in form of passive investment. Index funds abroad have
grown as a consequence of the expansion of the pension fund industry. Investments
by institutional investors in Index funds (retirement plans and endowment funds)
have grown from $ 10 billion in 1980 to more than $1.3 trillion by the end of
2008. The Vanguard group is the leader in Index funds worldwide. Galaxy,
Fidelity, Merill Lynch are the other mutual funds providing Indexation.
Interest in Index funds spread from the US markets to the UK. Once again, it was
the pension funds, which represented a major portion of the institutional assets
that were Indexed in the U.K market. The wave of Indexation continued into
continental Europe, the Middle East. However, in Asia, with the exception of
Japan, Indexation is still in its infancy.
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.”
(With reference to the proviso to clause 10 of Seventh Schedule to the SEBI
(Mutual Funds) Regulations, 1996 circulated on Jan 5, 2000 )
According to the new clause 10, Seventh schedule of the SEBI (Mutual funds)
(Amendments) Regulations 1999 :
“No mutual fund scheme shall invest more than 10 per cent of its NAV in the
equity shares or equity related instruments of any company.
Provided that, the limit of 10 per cent shall not be applicable for investments
in Index fund or sector or industry specific scheme".
| Information Courtesy : |
 |
|
