What is an index? We will start with single-line definition, then we will go into deep. An index is a tool which tracks and manages the value of anything… …starting from a reference point. So, what does it mean?
What is an index ?
Index is anything which tracks, measures, and benchmark something. So, basically, let’s say, it’s tracking a sector, it is measuring its performances, and is also being used as a benchmark by various other agencies and investors and mutual fund houses or anybody. for example India’s most popular indices are NIFTY 50 and Sensex 30.
Importance of an index
Let’s first imagine that… there is no such index.
How any investor user will measure the performance of Indian stock market? How he will know that how the India stock market and India, in general, is doing?
Then, the second point is, if there is no index, how will you select in which stock, in which industry, in which sector you have to put money.
And the third most important thing is, if there is no index then the stocks and mutual funds which you already hold, how will you know how they are performing? Are they doing good or they are bad or like what?
Formation of Dow Jones Industrial Average
Because of above major reasons in 1884, Charles Dow and Edward Jones launched first index in the USA which was called Dow Jones Transportation Average. And that index actually had 11 companies in it and its objective was to measure the health of railroad and transportation sector of US.
And the reason why they launched is because transportation sector in US was bustling with economic activities and a lot of interest from various investors were coming into that sector.
Essentially, later, after few days they launched one of the biggest known indices of US, Dow Jones Industrial Average. Its main purpose is to track most of the major industries of USA and it’s one of the biggest indices of the world.
Like I told you, index always keeps tracking something, hence, there are some underlying constituents to it which form the index. Dow Jones Transportation Index was made up of 11 companies and those 11 companies were measuring transportation sector.
CPI in India and some other Indices
CPI, one of the most popular index called consumer price index. It’s main motive is to measure the inflation. Just like the Nifty 50 has 50 constituents. It’s a basket of 50 stocks, consumer price index is also an index which has its own basket andit has different types of items like food items, fuel items. All these items comprise CPI index ( consumer price index).
And over the time frame as the prices of these items change in the economy, the value of CPI changes and we get the final figure of inflation.
For example. Urban CPI increased by 9 percent on annual basis (June 2020 to June 2019) and decreased by 0.2 percent on monthly basis (June 2020 to May 2020). The annual average inflation rate between June 2020 and June 2019 was 6.3 percent.
Like we have seen now that CPI measures the inflation rate in India, similarly, if you want to measure the performance of auto sector in India, there is a Nifty Auto Index. You can check it and see its performance.
Then, if you want to measure the performance of IT industry in india, there is Nifty IT Index. Similarly, lot of the indices for most of the sectors and the market segments which you can track and see.
Similarly, if you want to check the performance of the external market, for example, if you want to check the performance of stock market of US there are two prominent indices, S&P 500 and Dow Jones industrial average.
If you want to see the performance of stock market of France, there is CAC-40. For UK, there is Russel For Japan, there is NIKKEI-225. So, there are lots of indices across countries where you can measure the performance of stock market of the countries. You can measure the performance of their industries, their sectors.
Every index has predefined companies in it. There is fix set of companies. Like, Nifty 50 has 50 companies, Sensex 30 has 30 companies in it.
How did these companies come? There are predefined set of rules and methodologies behind every index. When you apply these rules, you get to have these companies. For example,
when Nifty 50 was formed, some set of rules was applied. After applying those rules, we came with 50 companies. Similarly, for Sensex 30,the same thing is applicable. These predefined rules are decided once and in the normal course, they don’t change.
Every quarterly or may be every year, there is an index committee which sits and sets these rules or on the basis of these rules, constituents are selected and finally the same constituents are fixed for the forth coming index. This is how index, its rules and selection of stocks work.
How to invest in index fund ?
Since we have talked about index we know what is an index and what it’s purpose. Now suppose you want to invest in the Indian Auto industry or auto index, how to do that ?
There are three ways to buy any index.
- First is to directly buy all the companies of that index in the same proportion.
- Second is to buy through an Index mutual fund.
- And the third method is through ETFs.
When you directly buy all the stocks in the same weights you need a lot of capital, initial investment. Let’s understand it with an example.
In this example, portfolio is the index of five stocks.
Simultaneously, you can see the weights and prices. It’s an equal-weighted portfolio. All stocks have a weight of 20%.
Let’s understand what is a weight. Let’s consider, you have 100 Rs. If you invest 100Rs. in all five stocks, A, B, C, D, E distributing at the weight of 20%, it means you are buying stock A in 20 Rs., B in 20 Rs. and similarly 20 Rs. each for D and E. So, you have invested 20 Rs. each in these five stocks.
Back to the portfolio, as you can see, the portfolio is equal-weighted and has 5 stocks. As you have seen, prices of these stocks vary from 100 to 4 thousand Rs. Lets assume prices of these shares—
Price of A 100 rs
Price of B 100 rs
Price of C 100 rs
Price of D 100 rs
Price of E 4000 rs
Since fraction shares are not allowed in India, you have to buy minimum one share of any company. If you want to buy one share of the highest-priced company E you will have to invest 4 thousand Rs.
Like I have explained you through weight analogy. If 4000 is 20%, similarly, you have to invest 4 thousand rupess for A, B, C and D seperately, because you have equal-weighted portfolio.
So, total required amount to buy these shares is 20 thousand Rs. This means you will need 20 thousand Rs. to buy this index to invest for the first time.
This was an hypothetical example. Nifty 50 have 50 such stocks. Imagine, if in this example, you need20 thousand Rs. for five stocks for 50 stocks, the amount can go up to 50 thousand or 100 thousand.
How to invest in ETF ?
Second option is buying through index mutual fund, this is a broad topic we will cover it in some other article, here we will prefer third method, investing in index through ETF.
This is considered as the best way because ETF is created just like mutual fund, that after pulling money from lots of investors, units are formed and investors can buy those units directly through their brokers. Price of the units is very low.
For example, if you want to buy ETF of Nifty 50 there are many mutual fund houses and AMC, who have launched ETFs of Nifty 50. for example, SBI Nifty 50 ETF. Cost of SBI Nifty 50 ETF is around 120 Rs. So, you can invest in Nifty 50 index through investment of 120 Rs.
When you wanted to buy directly all 50 stocks, amount was much greater which can be 100 thousand or 200 thousand, here you took exposure in Nifty 50 index just for Rs. 120.
Similarly, other AMCs like Kotak Nifty 50ETF has price of around 118-120. Then there is Reliance Nifty 50ETF, created by Reliance AMC, it’s price is around Rs. 1200.
Through this method, you can invest in index at a very low cost.
What is an ETF ?
ETF is just like a mutual fund, ETF also has a basket of securities underlying in it. It is also tracking some index. Similar to a mutual fund, by pulling money from lots of investors, ETF creator or ETF manufacturer, which is a mutual fund house, creates ETF units. After pulling money from lots of people, it goes to ETF fund house and they buy securities from that money and they issue units of the ETF.
The biggest difference of ETF units compared to mutual fund units is you need a demat and a trading account to buy or sell ETF. It’s just like trading a stock. whereas if you want to buy a mutual fund you directly go to your Asset Management Company or fund house and buy mutual funds from the company rather than through a broking account because mutual funds are not traded like a stock or ETF. It is the biggest difference between mutual funds and ETFs.
We have read in this article, what is an index why indices are constructed, how they are constructed to measure the performance of any stock market, GDP of a country to measure the inflation, indices are made. How users or investors can take exposure in indices directly for that we talked about investing in index through ETFs. We learned about the major differences between ETFs and mutual funds.