There is a lot of news each day regarding different indices. For example, you might hear that the Nifty or Sensex fell by a certain number of points or increased by a certain number of points. What does it mean? Does it change anything for investors? Will it affect the way you invest? Should it matter to you? Read on to find out about this.
What is an index?
In order to understand the effect of an index, you should first know what an index is. An index is merely a set of securities that represent one part of the market. There are a number of indices in India such as the Sensex, Nifty, and so on. BankBazaar has more information regarding the same. If we take the example of the Nifty 50, it is composed of a number of stocks in the domestic market. These stocks are the largest with regard to market capitalisation. This list is not fixed permanently. It tends to change with changes in the market. Similarly, there are other indices like the S&P BSE Sensex, Nifty Midcap Index, and so on. These are all indices that rely on different parameters. For instance, the Nifty Midcap Index relies on medium-size stocks.
How are stocks added to the indices?
Since there are a number of indices with various parameters, each company’s stock is added to the respective index after careful consideration. Usually, each index composition is reviewed two times each year, once in June and once in December. This is because daily changes can be exhausting and potentially confusing. Doing this review two times during the course of a year gives a better perspective to the evaluators. There are certain indices that are reviewed each quarter. These are typically specialised indices. IISL is a subsidiary of the NSE that constructs, generates, and maintains indices for marketwatch. In addition to the factors mentioned here, there is a condition that any new stock added to the index should be proportionate to the weight allocated to it in the index.
Are there changes to the indices?
Yes, there are changes to the indices. Depending on a certain company’s performance and other factors like market capitalisation, its ranking will change. Then, depending on the objectives of the indice the company is listed under, the company is either added to, retained, or removed from an index. It is possible for a majority of the companies in an index to get replaced by other companies.
What are the impacts of changes in indices?
The major impact is on mutual funds and exchange traded funds or ETFs. If a person’s portfolio follows the index, then that portfolio is impacted by the changes in the index. Depending on changes to the index, with regard to replacement stocks, the transaction costs will also change for the investor. In addition, if one or more of the constituent stocks drops in price by a large value, then there will be a solid change in value of the index it forms a part of. For instance, if one of the stocks that makes up the Nifty 50 experiences a steep drop in prices due to some reason, then, the Nifty 50 will also reflect that change. While the entire index will not drop in value, there will be a noticeable effect.
Are the impacts short or long term?
To be fair, the impacts of the changes in the value is only in the short term. When it comes to the longer term, say three or five years, the changes in the index will change its nature as well. By nature of the index, we mean that the composition of the index will change over time. It so happens that big companies that make up the backbone of industry in the country eventually get replaced by fast moving consumer goods companies (FMCG companies) on the index. This is because the industry is not always considered by an index. If the stock performance of a certain company matches the requirements of the index, then the company will be added to the index.
In conclusion, it must be said that the impact of changes in indices is only in the short term. These changes will affect day traders and short-term investors more than people who have invested in stocks for a longer period of time. Through this, it can be seen that the average investor who chooses to invest for five years or more should be aware of changes to the index but need not necessarily actively make changes to his or her portfolio provided the company he or she has invested in is doing well.