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.