Nifty, Sensex a long way from truly representing

the economy
Rajesh Bhayani / Mumbai April 14, 2010, 0:28 IST

Nifty, the benchmark index of the National Stock Exchange (NSE), replaced
Grasim with Kotak Mahindra Bank last week. With this, the percent weight of the
banking and financial services (including housing finance) sector in the index
increased from 22.97 to 23.86. In 2005, it was 19.78.

The sector has the highest weight in Nifty as well as Sensex, the benchmark
index of the Bombay Stock Exchange, followed by oil & gas. However, going by
the weights of various sectors in these indices, they no more look like barometers
of the economy, as various heavyweights in the economy are almost not
represented.

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For instance, in the country’s gross domestic product, agriculture contributes
20.14 per cent and the trade sector 23.57 per cent. But, both are almost absent
from these benchmark indices. Vikash Khemani, co-head, institutions sales,
Edelweiss Capital, said: “These fairly represent the economy. However, one
should look at indices as representing the market. Within the listed companies,
they should be fairly representative, and that is there.”

Said Chetan Majithia, head of equities, Crisil, “Our study has shown that among
BRIC (Brazil, Russia, India and China) nations, Indian markets are more
diversified, and that is reflected in the indices.”
 

MEASURING WEIGHTS
Weight in Nifty Weight in Sensex
 
2005 2009 2010 2005 2009 2010

Banks & Finance 19.79 18.22 23.86 22.21 18.82 22.31

Oil & Gas 16.23 21.63 17.22 17.50 21.29 18.25

IT 15.99 10.72 12.10 15.52 12.08 13.84

Capital Goods 4.39 8.74 9.94 4.48 8.75 9.98

Metals & Steel 8.18 3.86 8.56 8.26 3.50 7.22

FMCG 8.98 11.81 7.72 9.84 13.67 9.18

Automobile 6.84 3.80 5.20 5.05 4.39 6.18

Power Generation  2.33 5.71 4.32 2.65 5.21 4.24

Telecom-Service 4.93 7.85 3.75 4.57 7.43 3.62

Construction &
- 0.67 2.41 - 1.28 2.11
Realty
Pharmaceuticals 5.16 2.69 2.28 4.70 1.20 0.96

Gas Distribution 1.53 1.50 1.42 - 0.00 0.00

Cement 4.02 2.80 1.20 4.57 2.37 2.12

Others 1.62 0.00 0.00 0.64 0.00 0.00

For example, the Russian market’s composite index, MICEX, gives 50.01 per
cent weight to oil and gas and 19.56 per cent to the basic raw material sector.
Over two-thirds weight is of commodity-related sectors.

Brazil’s Bovespa index is heavy on basic raw materials (33.93) and oil and gas
(15.47). China’s Shanghai Stock Exchange’s index gives 32.35 per cent weight
to the financial sector but oil and gas, basic raw materials and industrials account
for nearly 48 per cent. Compared with these, Nifty and Sensex are widely
distributed and diversified.

Chetan says, “If you feel crude oil prices are going up, you go long on Russia,
and long on Brazil if commodity prices are moving up. If you want to diversify
risk, India is a better bet among BRIC nations.”

In terms of weights globally, most developed markets’ indices differ. Nikkei 225
gives 28.08 weight to industrials, 20.16 per cent to consumer goods and only
6.15 per cent to the financial sector. FTSE gives the highest (21 per cent) weight
to financials, while the Hang Seng is overweight on the financial sector (58.15
per).

For the premier Stock Exchange that pioneered the stock broking
activity in India, 128 years of experience seems to be a proud
milestone. A lot has changed since 1875 when 318 persons became
members of what today is called “The Stock Exchange, Mumbai” by
paying a princely amount of Re1.

Since then, the country’s capital markets have passed through both
good and bad periods. The journey in the 20th century has not been
an easy one. Till the decade of eighties, there was no scale to measure
the ups and downs in the Indian stock market. The Stock Exchange,
Mumbai (BSE) in 1986 came out with a stock index that subsequently
became the barometer of the Indian stock market.

SENSEX is not only scientifically designed but also based on globally

accepted construction and review methodology. First compiled in 1986,
SENSEX is a basket of 30 constituent stocks representing a sample of
large, liquid and representative companies. The base year of SENSEX
is 1978-79 and the base value is 100. The index is widely reported in
both domestic and international markets through print as well as
electronic media.

The Index was initially calculated based on the “Full Market

Capitalization” methodology but was shifted to the free-float
methodology with effect from September 1, 2003. The “Free-float
Market Capitalization” methodology of index construction is regarded
as an industry best practice globally. All major index providers like
MSCI, FTSE, STOXX, S&P and Dow Jones use the Free-float
methodology.

Due to is wide acceptance amongst the Indian investors; SENSEX is

regarded to be the pulse of the Indian stock market. As the oldest
index in the country, it provides the time series data over a fairly long
period of time (From 1979 onwards). Small wonder, the SENSEX has
over the years become one of the most prominent brands in the
country.

The growth of equity markets in India has been phenomenal in the

decade gone by. Right from early nineties the stock market witnessed
heightened activity in terms of various bull and bear runs. The SENSEX
captured all these events in the most judicial manner. One can identify
the booms and busts of the Indian stock market through SENSEX.

SENSEX Calculation Methodology

SENSEX is calculated using the “Free-float Market Capitalization”

methodology. As per this methodology, the level of index at any point
of time reflects the Free-float market value of 30 component stocks
relative to a base period. The market capitalization of a company is
determined by multiplying the price of its stock by the number of
shares issued by the company. This market capitalization is further
multiplied by the free-float factor to determine the free-float market
capitalization.

The base period of SENSEX is 1978-79 and the base value is 100 index
points. This is often indicated by the notation 1978-79=100. The
calculation of SENSEX involves dividing the Free-float market
capitalization of 30 companies in the Index by a number called the
Index Divisor. The Divisor is the only link to the original base period
value of the SENSEX. It keeps the Index comparable over time and is
the adjustment point for all Index adjustments arising out of corporate
actions, replacement of scrips etc. During market hours, prices of the
index scrips, at which latest trades are executed, are used by the
trading system to calculate SENSEX every 15 seconds and
disseminated in real time.

Dollex-30

BSE also calculates a dollar-linked version of SENSEX and historical

values of this index are available since its inception. (For more details
click ‘Dollex series of BSE indices’)

Understanding Free-float Methodology

Concept:

Free-float Methodology refers to an index construction methodology

that takes into consideration only the free-float market capitalization
of a company for the purpose of index calculation and assigning weight
to stocks in Index. Free-float market capitalization is defined as that
proportion of total shares issued by the company that are readily
available for trading in the market. It generally excludes promoters’
holding, government holding, strategic holding and other locked-in
shares that will not come to the market for trading in the normal
course. In other words, the market capitalization of each company in a
Free-float index is reduced to the extent of its readily available shares
in the market.
In India, BSE pioneered the concept of Free-float by launching BSE
TECk in July 2001 and BANKEX in June 2003. While BSE TECk Index is
a TMT benchmark, BANKEX is positioned as a benchmark for the
banking sector stocks. SENSEX becomes the third index in India to be
based on the globally accepted Free-float Methodology.

Major advantages of Free-float Methodology:

A Free-float index reflects the market trends more rationally as it takes

into consideration only those shares that are available for trading in
the market.
*
Free-float Methodology makes the index more broad-based by
reducing the concentration of top few companies in Index. For
example, the concentration of top five companies in SENSEX has fallen
under the free-float scenario thereby making the SENSEX more
diversified and broad-based.
*
A Free-float index aids both active and passive investing styles. It aids
active managers by enabling them to benchmark their fund returns
vis-à-vis an investable index. This enables an apple-to-apple
comparison thereby facilitating better evaluation of performance of
active managers. Being a perfectly replicable portfolio of stocks, a
Free-float adjusted index is best suited for the passive managers as it
enables them to track the index with the least tracking error.
*
Free-float Methodology improves index flexibility in terms of including
any stock from the universe of listed stocks. This improves market
coverage and sector coverage of the index. For example, under a Full-
market capitalization methodology, companies with large market
capitalization and low free-float cannot generally be included in the
Index because they tend to distort the index by having an undue
influence on the index movement. However, under the Free-float
Methodology, since only the free-float market capitalization of each
company is considered for index calculation, it becomes possible to
include such closely held companies in the index while at the same
time preventing their undue influence on the index movement.
*

Globally, the Free-float Methodology of index construction is

considered to be an industry best practice and all major index
providers like MSCI, FTSE, S&P and STOXX have adopted the same.
MSCI, a leading global index provider, shifted all its indices to the
Free-float Methodology in 2002. The MSCI India Standard Index, which
is followed by Foreign Institutional Investors (FIIs) to track Indian
equities, is also based on the Free-float Methodology. NASDAQ-100,
the underlying index to the famous Exchange Traded Fund (ETF) –
QQQ is based on the Free-float Methodology.

Definition of Free-float:

Share holdings held by investors that would not, in the normal course
come into the open market for trading are treated as ‘Controlling/
Strategic Holdings’ and hence not included in free-float. In specific, the
following categories of holding are generally excluded from the
definition of Free-float:

* Holdings by founders/directors/ acquirers which has control element

* Holdings by persons/ bodies with “Controlling Interest”
* Government holding as promoter/acquirer
* Holdings through the FDI Route
* Strategic stakes by private corporate bodies/ individuals
* Equity held by associate/group companies (cross-holdings)
* Equity held by Employee Welfare Trusts
* Locked-in shares and shares which would not be sold in the open
market in normal course.

The remaining shareholders would fall under the Free-float category.

Determining Free-float factors of companies:

BSE has designed a Free-float format, which is filled and submitted by

all index companies on a quarterly basis with the Exchange. (Format
available on www.bseindia.com) The Exchange determines the Free-
float factor for each company based on the detailed information
submitted by the companies in the prescribed format. Free-float factor
is a multiple with which the total market capitalization of a company is
adjusted to arrive at the Free-float market capitalization. Once the
Free-float of a company is determined, it is rounded-off to the higher
multiple of 5 and each company is categorized into one of the 20
bands given below. A Free-float factor of say 0.55 means that only
55% of the market capitalization of the company will be considered for
index calculation.

Free-float Bands:

% Free-Float

Free-Float Factor
% Free-Float

Free-Float Factor

>0 – 5%

0.05

>50 – 55%

0.55

>5 – 10%

0.10

>55 – 60%

0.60

>10 – 15%

0.15

>60 – 65%

0.65

>15 – 20%

0.20

>65 – 70%
0.70

>20 – 25%

0.25

>70 – 75%

0.75

>25 – 30%

0.30

>75 – 80%

0.80

>30 – 35%

0.35

>80 – 85%

0.85

>35 – 40%

0.40

>85 – 90%

0.90
>40 – 45%

0.45

>90 – 95%

0.95

>45 – 50%

0.50

>95 – 100%

1.00

Index Closure Algorithm

The closing SENSEX on any trading day is computed taking the

weighted average of all the trades on SENSEX constituents in the last
30 minutes of trading session. If a SENSEX constituent has not traded
in the last 30 minutes, the last traded price is taken for computation of
the Index closure. If a SENSEX constituent has not traded at all in a
day, then its last day’s closing price is taken for computation of Index
closure. The use of Index Closure Algorithm prevents any intentional
manipulation of the closing index value.

Maintenance of SENSEX

One of the important aspects of maintaining continuity with the past is

to update the base year average. The base year value adjustment
ensures that replacement of stocks in Index, additional issue of capital
and other corporate announcements like ‘rights issue’ etc. do not
destroy the historical value of the index. The beauty of maintenance
lies in the fact that adjustments for corporate actions in the Index
should not per se affect the index values.

The Index Cell of the exchange does the day-to-day maintenance of

the index within the broad index policy framework set by the Index
Committee. The Index Cell ensures that SENSEX and all the other BSE
indices maintain their benchmark properties by striking a delicate
balance between frequent replacements in index and maintaining its
historical continuity. The Index Committee of the Exchange comprises
of experts on capital markets from all major market segments. They
include Academicians, Fund-managers from leading Mutual Funds,
Finance-Journalists, Market Participants, Independent Governing Board
members, and Exchange administration.

On-Line Computation of the Index:

During market hours, prices of the index scrips, at which trades are
executed, are automatically used by the trading computer to calculate
the SENSEX every 15 seconds and continuously updated on all trading
workstations connected to the BSE trading computer in real time.

Adjustment for Bonus, Rights and Newly issued Capital:

The arithmetic calculation involved in calculating SENSEX is simple,

but problem arises when one of the component stocks pays a bonus or
issues rights shares. If no adjustments were made, a discontinuity
would arise between the current value of the index and its previous
value despite the non-occurrence of any economic activity of
substance. At the Index Cell of the Exchange, the base value is
adjusted, which is used to alter market capitalization of the component
stocks to arrive at the SENSEX value.

The Index Cell of the Exchange keeps a close watch on the events that
might affect the index on a regular basis and carries out daily
maintenance of all the 14 Indices.

Adjustments for Rights Issues:

When a company, included in the compilation of the index, issues right
shares, the free-float market capitalisation of that company is
increased by the number of additional shares issued based on the
theoretical (ex-right) price. An offsetting or proportionate adjustment
is then made to the Base Market Capitalisation (see ‘Base Market
Capitalisation Adjustment’ below).

Adjustments for Bonus Issue:

When a company, included in the compilation of the index, issues
bonus shares, the market capitalisation of that company does not
undergo any change. Therefore, there is no change in the Base Market
Capitalisation, only the ‘number of shares’ in the formula is updated.

Other Issues:
Base Market Capitalisation Adjustment is required when new shares
are issued by way of conversion of debentures, mergers, spin-offs etc.
or when equity is reduced by way of buy-back of shares, corporate
restructuring etc.
* Base Market Capitalisation Adjustment:

The formula for adjusting the Base Market Capitalisation is as follows:

New Market Capitalisation
New Base Market Capitalisation = Old Base Market Capitalisation x
—————————————
Old Market Capitalisation
To illustrate, suppose a company issues right shares which increases
the market capitalisation of the shares of that company by say, Rs.100
crores. The existing Base Market Capitalisation (Old Base Market
Capitalisation), say, is Rs.2450 crores and the aggregate market
capitalisation of all the shares included in the index before the right
issue is made is, say Rs.4781 crores. The “New Base Market
Capitalisation ” will then be:
2450 x (4781+100)
————————– = Rs.2501.24 crores
4781

This figure of 2501.24 will be used as the Base Market Capitalisation

for calculating the index number from then onwards till the next base
change becomes necessary.

Back

SENSEX – Scrip selection criteria:

The general guidelines for selection of constituents in SENSEX are as

follows:

* Listed History:
The scrip should have a listing history of at least 3 months at BSE.
Exception may be considered if full market capitalisation of a newly
listed company ranks among top 10 in the list of BSE universe. In
case, a company is listed on account of merger/ demerger/
amalgamation, minimum listing history would not be required.
* Trading Frequency:
The scrip should have been traded on each and every trading day in
the last three months. Exceptions can be made for extreme reasons
like scrip suspension etc.
* Final Rank:
The scrip should figure in the top 100 companies listed by final rank.
The final rank is arrived at by assigning 75% weightage to the rank on
the basis of three-month average full market capitalisation and 25%
weightage to the liquidity rank based on three-month average daily
turnover & three-month average impact cost.
* Market Capitalization Weightage:
The weightage of each scrip in SENSEX based on three-month average
free-float market capitalisation should be at least 0.5% of the Index.
* Industry Representation:
Scrip selection would generally take into account a balanced
representation of the listed companies in the universe of BSE.
* Track Record:
In the opinion of the Committee, the company should have an
acceptable track record.

Index Review Frequency:

The Index Committee meets every quarter to discuss index related

issues. In case of a revision in the Index constituents, the
announcement of the incoming and outgoing scrips is made six weeks
in advance of the actual implementation of the revision of the Index.
Back
History of replacement of scrips in SENSEX

Date

Outgoing Scrips

Replaced by

01.01.1986

Bombay Burmah

Voltas

Asian Cables

Peico

Crompton Greaves

Premier Auto.

Scinda

G.E.Shipping

03.08.1992

Zenith Ltd.

Bharat Forge

19.08.1996
Ballarpur Inds.

Arvind Mills

Bharat Forge

Bajaj Auto

Bombay Dyeing

BHEL

Ceat Tyres

BSES

Century Text.

Colgate

GSFC

Guj. Amb. Cement

Hind. Motors

HPCL

Indian Organic

ICICI

Indian Rayon
IDBI

Kirloskar Cummins

IPCL

Mukand Iron

MTNL

Phlips

Ranbaxy Lab.

Premier Auto

State Bank of India

Siemens

Steel Authority of India

Voltas

Tata Chem

16.11.1998

Arvind Mills

Castrol

G. E. Shipping
Infosys Technologies

IPCL

NIIT Ltd.

Steel Authority of India

Novartis

10.04.2000

I.D.B.I

Dr. Reddy’s Laboratories

Indian Hotels

Reliance Petroleum

Tata Chem

Satyam Computers

Tata Power

Zee Telefilms

08.01.2001

Novartis

Cipla Ltd.
07.01.2002

NIIT Ltd.

HCL Technologies

Mahindra & Mahindra

Hero Honda Motors Ltd.

31.05.2002

ICICI Ltd.

ICICI Bank Ltd.

10.10.2002

Reliance Petroleum Ltd.

HDFC Ltd.

10.11.2003

Castrol India Ltd.

Bharti-Tele-Ventures Ltd.

Colgate Palomive (India) Ltd.

HDFC Bank Ltd.

Glaxo Smithkline Pharma. Ltd.

ONGC Ltd.

HCL Technologies Ltd.

Tata Power Company Ltd.

Nestle (India) Ltd.

Wipro Ltd.

19.05.2004

Larsen & Toubro Ltd.

Maruti Udyog Ltd.

27.09.2004

Mahanagar Telephone Nigam Ltd.

Larsen & Toubro Ltd.

06.06.2005

Hindustan Petroleum Corp Ltd.

National Thermal Power Corpn. Ltd.

Zee Telefilms Ltd.

Tata Consultancy Services Ltd.

12.06.2006
Tata Power Ltd.

Reliance Communiation Ventures Ltd.

09.07.2007

Hero Honda Motors Ltd.

Mahindra & Mahindra Ltd.

19.11.2007

Dr. Reddy’s Laboratories Ltd.

DLF Ltd.

14.03.2008

Bajaj Auto Ltd.

Jaiprakash Associates Ltd.

28.07.2008

Ambuja Cements Ltd.

Sterlite Industries Ltd.

Cipla Ltd.

Tata Power Co. Ltd.