This Article was originally published in The Global Analyst

A good understanding of benchmarks holds key to outperforming the markets or generating alpha returns.

“Nifty 50 breached 21,000 in a historic high” goes the headline! 

Good or bad, stock market stories always revolve around the index, be it Nifty 50 or Sensex. The role of index goes beyond creating daily headlines. Producing and maintaining an index has become a huge industry for capital market players, especially fund managers and index providers. In simple terms, index represents the performance of a group of stocks based on a certain criterion. The criteria could be the largest stocks (large cap) or dividend yield or pharma sector to name a few. The stock market exhibits a skew when it comes to underlying stocks with large companies enjoying a disproportionate share of the total. For e.g., large cap accounts for nearly 70% of total market cap while it accounts only for 2% of total stocks while small cap accounts for 95% of total stocks but accounts only for 15% of total market cap. Even worse, measured from a median point of view, small cap median market cap at Rs.50 cr. is just 0.05% of large cap median market cap. This skew matters a great deal when it comes to index construction. While it is possible to have all the 100 stocks incorporated into an index (Nifty 100), when it comes to small cap one can consider only the top 250 stocks out of nearly 5,000 small cap stocks. 

Another interesting dimension is the user side of the index which are mainly mutual funds. A look at the data provided by the Association of Mutual Funds of India (AMFI) shows that we have 1,350 mutual funds spread across several types, of which equity-oriented funds (42%) and debt-oriented funds (28%) comprise the bulk. A growing but important category is currently lumped under “Other schemes” which mainly comprise of index funds and Exchange Traded Funds (ETFs). 

A broad appreciation of the total market size as well as number of mutual funds provide the basis to understand the index world. Indexing is essentially slicing and dicing within a set universe. For e.g., Nifty indices which are launched and maintained by National Stock Exchange revolves around 750 stocks and the top 50 designated as Nifty 50 while the top 100 is designated as Nifty 100. Index providers come up with these slices and dices in the hope that funds would eventually launch based on those and hence a gradual adoption of them as benchmarks. 

The two main providers of indices in India happen to be National Stock Exchange (through NSE Indices limited) and Bombay Stock Exchange (through S&P). The NSE has a 75% market share in terms of both number of indices adopted by fund managers and consequent share of assets under management. Since indices are used as benchmarks both for active and passive management of funds, they become important from several angels. Some of them are explained here:

1. Alpha Computation: The main marketing pitch of active fund managers is alpha generation, which is technically defined as the excess return over the stated benchmark. Hence, the choice of index is critical and should be aligned with the overall objective of the fund. For e.g., a large cap fund cannot have a large and midcap benchmark and vice-versa. Appropriateness of the benchmark can be vital to attract institutional investors that come with a sophisticated understanding of the investment industry. 
2. Price Vs. Total Return: Initially index launches were mainly based on price returns that ignored the dividends. However, this shortcoming has been removed with the launch of total return index that now accounts for dividends. Hence, we can make apples to apples comparison between fund managers and benchmarks.
3. Providers: As said before, NSE has a lion’s share when it comes to index adoption by fund managers (75%). While choosing between NSE and BSE (S&P) for selecting the benchmark index, one should look at the methodology carefully before deciding. 
4. Regular Vs. Direct: Mutual fund purchasing can be done either directly or through distributors. The latter is termed as regular plans while the former is termed as direct plans. Direct plans will not have costs associated with distributors and hence performance of direct will be superior to regular plans. Given the fact that both will have the same benchmarks, no wonder the alpha generated for direct plans will be higher compared to regular plans.
5. Tracking Error: This simply measures the deviation a fund manager takes from the stated benchmark constituents to generate more alpha. While that is the intention, it can cut both ways if the stock selection is bad which can result in negative alpha. Needless to say, that index funds or ETF’s will the lowest tracking error as they are paid to just hug the index. The higher the tracking error for a fund, the higher the risk.

Case Study: Large Cap

The role of index can best be explained by taking a subset of equity indices for a deeper look. Among the equity categories, large cap is the largest in terms of assets under management. Ignoring funds with less than one year of track record, we can count 30 large cap equity mutual funds managing Rs.286,914 crores. Majority (66%) of the funds are benchmarked to Nifty 100 Total Return index while the rest are benchmarked to the S&P BSE 100 Total Return index. It is interesting to note while both indices take the top 100 companies by market cap, however small differences in the list of constituents of these indices produce difference in terms of their performance. The return across time periods (1 year, 3 years and 5 years) were lower for S&P BSE 100 TR index compared to Nifty 100 due to which the alpha generated using the S&P BSE index is lower than the Nifty 100 TR index. Hence, choice of appropriate index to benchmark becomes crucial. As a side note, it can also be observed that while active fund mangers were successful in generating good alpha in the shorter term (1 year), alpha generated for longer periods came down (for 3 years) and completely vanished for 5 years! The problem is further exacerbated by regular vs direct investing approach. As explained earlier, regular option performance will invariably be lower than direct due to distributor fees charged.  That is a different study altogether! 

In a nutshell

In conclusion, we can say that the index world may look unassuming but can be hugely important. Since 1996, NSE has launched over 100 indices spanning four main segments i.e., the broad market indices, sector indices, thematic indices, and strategy indices. Given the increasing options facing fund managers, it is important to choose appropriate indices, which can affect alpha generation by fund managers. Managers struggling to generate alpha must have taken higher tracking error than otherwise. Also, investors should appreciate the subtle but critical difference between price returns and total returns as well as regular vs. direct options. Benchmarks are central to all such studies and evaluation and hence the focus.

Happy Investing!