Employing stock indices to generate market-beating returns

P Saravanan Posted online: Tuesday, Mar 11, 2014 at 0000 hrs
It’s said that a country’s stock indices are the barometer of its capital markets as well as the economy. With leading indices touching new highs, it is essential to understand them and how they function.

Although portfolios are composed of many different stocks, investors typically ask, “What happened to the market today?” The reason for this question is that if an investor owns more than a few stocks, it is cumbersome to follow each share individually to determine the portfolio’s composite performance. Also, there is a notion that most individual shares move with the aggregate market. Therefore, if the overall market rises, an individual’s portfolio is likely to increase in value as well.

One of the oldest stock exchanges in India is the Bombay Stock Exchange (BSE), whose main index is widely known as the Sensex. This index constitutes thirty component stocks representing large, well-established and financially sound companies across key sectors. The selection of companies is based on broad parameters such as listed history, trading frequency, industry representation, track record and the like.

The index was first compiled in 1986 with the market capitalisation methodology, considering 1978-79 as the base year. Owing to various reasons, a free-float market methodology was adopetd on September 1, 2003. Apart from the key index, the exchange also developed over a period various sectoral indices such as Auto, Bankex, FMCG, IT, Metal, Mid-Cap, Oil and Gas, Power and Realty, to name a few.

The closing value on any trading day is computed by taking the weighted average of all the trades on the Sensex constituents in the last thirty minutes of the trading session. The BSE index committee meets every quarter to discuss index-related issues. In case of a revision in the constituents, an announcement on incoming and outgoing scrips is made six weeks in advance of the actual implementation of the revision.

Using the indices

Stockmarket indices have several uses for an individual investor. A primary application is to use the index values to compute total returns for the aggregate market, or for some component, over a specified period, and to use the rates of return and risk measures computed as a benchmark to judge the performance of individual portfolios.

A basic assumption while evaluating portfolio performance is that an investor should be able to experience a risk-adjusted rate of return comparable to the market’s by randomly selecting a large number of shares. So, a smart investor should consistently do better than the market. An aggregate stock index can be used as a benchmark to judge portfolio performance.

Index-mirroring portfolio

Normally, it is difficult for an individual investor to consistently outperform specified market indices. So, an obvious alternative is to invest in a portfolio that emulates the market. This led to the creation of what is called an index fund, whose purpose is to track the performance of specified market indices over time.

Stock analysts, portfolio managers and individual investors use indices to examine the factors influencing aggregate stock price movements. Another group interested in market indices is that of technical analysts, who believe past price changes can be used to predict future price movements. Technicians plot and analyse price and volume changes for stockmarket indices to assess the direction of future share price.

To conclude, market indices can be used to measure the historical performance of an asset class, and can also be used as benchmarks to evaluate the performance of a money manager overseeing a mutual fund or a pension plan. From an individual investor’s point of view, whenever you invest, you examine numerous market indices that tell you what has happened and how successful you have been. The selection of appropriate indices will depend on how knowledgeable you are when it comes to various series.

* The writer is associate professor of finance and accounting at IIM Shillong