August 24, 2007

life in financial markets: new nifty-sensex dynamic


"Everything is the same except the name", say the various sets of twins in the adverts for UTI Bank changing its name to Axis Bank. Watching news channels in the night or reading their newspapers next morning, many tend to say the same thing about the twin barometers of the country's stock market performance, Nifty and Sensex. But here, since the last four years, "nothing has been the same except the game." For some good reasons.

Its not that Nifty, or S&P CNX Nifty as is its formal name, is run by India Index Services & Products (IISL), a joint venture between National Stock Exchange and Crisil, and Sensex, or Sensitive Index as is its formal name, is run by the Bombay Stock Exchange. Both claim to be the best barometer of Indian stock market. Nor is it because Nifty is made up of 50 stocks and Sensex 30 stocks if we go by market analysts' claims that most portfolios having 20-25 diversified large cap stocks will return almost the same percentage profits or losses no matter what their composition.

Its because on September 1, 2003 the BSE changed the way it calculated Sensex from a market capitalisation-weighted index to a free float capitalisation-weighted index. IISL was continuing with the market cap-weighted approach for Nifty. Its time to take stock of how much impact has this change made in the movements of Sensex and Nifty when we co-relate them for the period leading uptil now and a similar period prior to the change.

New dynamic. The two graphs below tells us that the daily co-relation between the two indices didn't suffer greatly but it did result in their returns switching sides. From September 2003 to now is four years and the Sensex has returned 338.3% moving up from 4244 on August 29, 2003 to 14358 on August 17 this year. The Nifty, in this time, has returned 302.8% moving up from 1356 to 4108, and that is a difference of 25% in returns between the two. It was the reverse from September 1999 to August 2003. Sensex was down by 13.3% from 4898 to 4245 Nifty was down by a much smaller 3.9% from 1412 to 1357.






The cause... Due to its free float methodology Sensex is using a part of the total market capitalisation of its stocks. For instance, at August 17 closing prices, the current Sensex stocks had a combined total market capitalisation of Rs 18,61,500 crore but the BSE was using only Rs 9,35,600 crore of it as the free float part to calculate the Sensex.

An index value at any given point reflects the sum of market cap (total or free float as the case may be) of all the index stocks in relation to the corresponding market cap on a specified base date. If you start an index today with 10000 as the base value then if the sum of market cap of its stocks falls from say Rs 1,00,000 crore today to Rs 95,000 crore tomorrow then your index value tomorrow will be 9500. Of course, the base market cap has to be adjusted whenever there the share capital of a stock changes.

Based on quarterly disclosure by companies on its shareholding pattern, BSE's index committee decides which shareholding of Sensex companies are to be considered as promoter or having controlling interest in the company and then calculates the market cap for the remaining shareholding only. For instance, if it finds 61 per cent of Bharti Airtel's total market cap to be of such kind then after rounding it to 65 per cent it uses only 35 per cent of it.

Now, a 10 per cent rise in Bharti's share price will impact a full market cap-weighted index more than a free float-weighted index because the former uses 100 as the base and the latter only 35. As a result of such impacts, among the 29 stocks common to Sensex and Nifty, weights vary much more than they otherwise would based only due to additional 20 stocks in Nifty. See the table below.


WEIGHTY DIFFERENCES

Security Full market cap (Rs crore) used in Nifty1 % of full market cap used in Sensex
Weight in Nifty (%) 1
Weight in Sensex (%) 1
Reliance Industries 244254 50
11.38
13.06
ONGC 167409 20
7.81
3.58
Bharti Airtel 150728 35
7.05
5.64
NTPC 134401 15
---
2.16
Infosys Technologies 106094 85
4.94
9.63
TCS 103349 20
4.82
2.21
Reliance Communication 100891 35
4.70
3.78
ICICI Bank 91810 100
4.21
9.66
State Bank of India 79971 45
3.73
3.85
BHEL 76308 35
3.56
2.86
Wipro 69380 20
3.23
1.48
Larsen & Toubro 65512 90
3.08
6.36
ITC 57693 70
2.69
4.32
SAIL 56772

2.65
---
HDFC 51239 90
2.37
4.93
Reliance Petroleum 49140

2.29
---
Hindustan Unilever 42420 50
1.98
2.27
HDFC Bank 37741 80
1.76
3.23
Sterlite Industries 36608

1.71
---
Suzlon Energy 33856

1.58
---
Tata Steel 33167 70
1.54
2.48
Satyam Computer 29400 95
1.37
2.99
Grasim 25117 75
1.17
2.01
GAIL 25065

1.17
---
Tata Motors 24713 60
1.15
1.59
Bajaj Auto 22775 65
1.06
1.58
Maruti Udyog 22543 45
1.05
1.08
ABB 21714

1.01
---
Siemens 20061

0.94
---
HCL Tech 19940

0.93
---
Ambuja Cement 19269 65
0.90
1.34
Sun Pharma 18568

0.86
---
ACC 17853 60
0.83
1.14
Hindalco 17186 70
0.80
1.29
Reliance Energy 16442 70
0.76
1.32
National Aluminum 16092

0.75
---
M&M 15980 80
0.74
1.36
Punjab National Bank 15171

0.71
---
Cipla 14302 65
0.67
0.99
Tata Power 13879

0.68
---
Ranbaxy Laboratories 13099 70
0.61
0.98
Zee Entertainment 12654

0.59
---
Hero Honda 12454

0.58
---
BPCL 11117

0.52
---
VSNL 10552

0.49
---
IPCL 10525

0.49
---
Dr Reddys 10506 75
0.49
0.84
Glaxosmithkline 9512

0.44
---
Dabur 8587

0.40
---
MTNL 8426

0.39
---
HPCL 7643

0.36
---
1 - based on Aug 17 closing price






..and the ongoing debate.
The Nifty and the Sensex do not just serve as colourful indicators of market movement but investors in index funds and exchange traded funds (ETFs) actually make or lose money based on their movement. There are around 18 index funds of which around 12 are based on Nifty and the rest on Sensex. ETFs on indices are only four – one each on Nifty, Sensex, Junior Nifty and CNX Bank. See the table below.

Index Funds:









Nifty
Sensex



Franklin Templeton
2
1



UTI MF
2
1



HDFC MF
1
1



Birla MF
1





Canbank MF
1





LIC MF
1
1



Principal PNB
1





Reliance MF
1
1



SBI MF
1





Tata MF
1
1




ETFs:










Nifty
Sensex
Junior Nifty CNX Bank
Benchmark
1


1
1
ICICI Prudential


1




These funds have to mimic the index movements and keep their tracking errors low. They also have to keep their transaction costs the lowest in the industry. I asked an ETF manager in the country he said "We think the index should reflect whatever is there in the market and thats why the market-cap weighted indices choice for our ETFs. If the market thinks the free float of a company is very low there will be a illiquidity premium on it, so we are saying that let the market define that and let us not impose a number on it through a free float factor."

I sought the views of an independent scholar and he said "There is a certain body of economic theory, however good or bad, that accepts that only the market cap-weighted index gives the best Sharpe ratio." Sharpe's ratio gives the excess return (actual minus risk-free rate) on an investment for the extra volatility endured in holding the investment. "There is no comparable theory for free float-weighted index", he added. The BSE, on the other hand, claims on its website that "an index based on free float is more accurate and indicative of the actual trend."

Whether leaving out promoters holding, the crux of the matter, is good or not continues to get hotly debated across markets in the world. The independent scholar I spoke had this to day: "Is the promoter holding fixed? Not really. They transact. They respond to prices like you and me. He is a part of the normal market process. I am uncomfortable with this thing of the promoters being "up and there" that he is somehow external where the rest of us are in."

Even in the United States the popular Dow Jones index is not a full market cap index – its a evenly-weighted index where all stocks are assigned the same weight regardless of the size of the market cap. But the other popular index—S&P 500—is on total market cap method and is the one that majority of index funds and ETFs deployed in the US.

So, as an investor in an index fund or ETF, you might want to form your own opinion before you decided between a Nifty-based or a Sensex-based one.

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