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Here's all you need to know about index funds

Here's all you need to know about index funds

Here's all you need to know about index funds
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By CNBCTV18.com Contributor Aug 12, 2020 6:08:22 PM IST (Published)

Index Funds nowadays are a source of investment for investors looking at a long term and less risky forms of investment.

Authored by S Ravi

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Index Funds nowadays are a source of investment for investors looking at a long term and less risky forms of investment. The success of index funds depends on their low volatility and therefore the choice of the index as well. ETF or Exchange Traded Funds have become extremely popular in western economies.
NIFTY 50 is a benchmark-based index and the flagship of NSE, which showcases the top 50 equity stocks traded in the stock exchange. These stocks span across 13 sectors of the Indian economy which include – information technology, financial services, consumer goods, entertainment and media, financial services, metals, pharmaceuticals, telecommunications, cement and its products, automobiles, pesticides and fertilizers, energy, and other services.
NIFTY 50 follows the trends and patterns of blue-chip companies, i.e. the most liquid and largest Indian securities. Many of these stocks from the respective sectors are also listed on the benchmark index of the Bombay Stock Exchange, the SENSEX, which is composed of the top 30 ones.
Eligible Securities are all those equity shares that are at the NSE. The NIFTY share index is managed by a team of professionals at the NSE Indices Limited. It formed an Index Advisory Committee that offers its expertise and guidance on large-scale issues pertinent to equity indices.
Index Reconstitution:
Index maintenance plays a crucial role in ensuring the stability of the index. The indices are reconstituted semi-annually considering 6 months data ending January and July respectively.
The main stock selection criteria include the following beside a few others.
  • Companies ranked within top 800 based on both average daily turnover and average daily full market capitalization based on the previous six months period data.
  • The company's trading frequency should be at least 90% in the last six months.
  • The company should have a listing history of 6 months. A company that comes out with an IPO will be eligible for inclusion in the index if it fulfills the normal eligibility criteria for the index for a 3 month period instead of a 6 month period.
  • The review will take place on a semi-annual basis.
  • Further, on a quarterly basis indices will be screened for compliance with the portfolio concentration norms for ETFs/ Index Funds announced by SEBI on January 10, 2019.
  • Constituent capping of the indices is another crucial aspect, explained below.
    • Weights of each stock in these indices are calculated based on its free-float market capitalization such that no single stock shall be more than 33 percent and weights of top 3 stocks cumulatively shall not be more than 62 percent at the time of rebalancing.
    • This means that at the time of rebalancing of the index, no single constituent shall have a weightage of more than maximum capping limits as stated above.
    • NIFTY 50 indices are computed based on a float-adjusted and market capitalization-weighted method. In this method, the level of index demonstrates the aggregate market value of stocks present in the index in a specific base period.
      Such a base period for a NIFTY 50 index is November 3, 1995 where the base value of the index is considered 1000 and its base capital stands at Rs. 2.06 Trillion.
      The formula for calculating price index is listed below –
      Index value = Current MV or market value / (Base Market Capital * 1000)
      The methodology involved in the calculation of indices also considers changes in corporate actions, which for instance comprise of rights issuance, stock splits, etc.
      Usually, the ETFs track an index and are traded like normal stocks on exchange screens. A marker maker or two are appointed by the fund manager to give two-way quotes on the index ETF. A market maker’s job is to provide two-way quotes to the investors so that when they want to buy or sell the index fund, they are able to do instantaneously.
      The benefits of Index tracking ETFs or Index funds are many. These include the following.
      • Index funds take away the discretion the fund manager has on selecting stocks. The Index exactly by the fund manager, reducing a lot of conflict of interest situations in the fund management industry. Pension funds use this to avoid surprises in the fund returns.
      • All funds must report to the public their returns against a benchmark index. In India and abroad, over the last few decades, it has been observed that in the medium to long term, most funds underperform their benchmark indexes.
      • Internationally, the index fund is the largest fund management business and has grown exponentially over two decades compared to the active funds now. Index funds rule the investment horizon because they provide a better and transparent mechanism for investments, almost eliminate conflict of interest, reduce costs to the fund management company, etc
      • The cost of fund management companies includes distributors commission, fund manager salary, logistics for distributors, etc. When the index fund comes in, all these costs are taken away. The cost thus saved, also go to increasing investors' returns.
      • Each year in India, many AMcs charge 2 percent fees like management fees for active funds. In passive or index funds, the cost comes down to 0.01 percent in a few funds and would be usually lower than 0.20 percent. The entire savings and efficiency go to enhancing the returns for the investors. That’s why Internationally, the index funds have become the largest part of the fund management industry.
      • In India, the index funds have been existing for over 2 decades now. However, the active fund management industry doesn’t want to promote them as it reduces their income by 80 to 99 percent on similar funds under management depending on the fees they charge.
      • EPFO which manages funds for the organized sector employees started using index funds over the last few years since they were allowed to invest in the equities market.
      • In that sense, the ETF industry in India has got a push because of EPFO’s decision. Initially, they had selected, Nifty index of NSE and Sensex index of BSE in 75 percent: 25 percent ratio. After a review last year, based on the better performance of BSE’s Sensex index, they decided to change the ratio to 50: 50.
        The performance measurement of various indexes NSE Nifty, BSE Sensex and BSE 50 are given above in the table.
        S Ravi is Former Chairman of Bombay Stock Exchange
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