Re-jigging the index

Beating The Street

The other companies in the DJIA have all been replaced many times "" most of the market leaders of 1900 no longer exist as corporate entities.

An index needs to be updated as the marketplace changes and new companies gain dominance and new sectors increase in importance. This is especially so in a fast-changing environment like India.

The Sensex has had many recasts in its 20 years. Less than half the original 30 companies inducted in 1983 are still part of the index.

The latest changes are actually a double-whammy. Both aid market-watchers by giving a truer picture of market conditions. The computational method was recently switched over to free float from total market value and several Sensex companies are being replaced.

The purpose of an index is to give an overall picture of price movements. An index as narrow-focus as the Sensex is quite open to producing a misleading picture.

It is even possible to manipulate a narrow index by committing relatively small sums of money.

When the index is weighted by unadjusted market value the possibility of manipulation can increase.

In a weighted index, each individual stock price movement is multiplied by the ratio of that company's market value to market value of the entire index. Call this the market cap ratio or the weight.

Let's say 85 per cent of a large stock is held by the promoter and another 12 per cent is held by various financial institutions. That leaves a total of 3 per cent floating in the market and perhaps 1 per cent is traded on a regular basis.

It will be possible to cause a large movement in stock price by buying or selling a very small chunk of the company's total paid-up equity.

That large movement is further magnified when it's multiplied by the market cap ratio "" if the stock has 10 per cent weight it contributes disproportionately.

On the contrary, if an index is weighted by the ratio of free floats, such manipulations are more difficult.

In the context of Indian business the switch to free float was especially important. There are large companies like Wipro where the promoter does control 85 per cent of the stock.

There are even larger companies like ONGC and Indian Oil where the promoter, if one may call the government that, controls over 90 per cent.

Under an unadjusted market value regime, these stocks could contribute absurdly high amounts to a market index and leave it wide open to manipulation. Once the weights are adjusted for free float, the contributions are much more realistic.

Traders would note another secular trend. Everytime new stocks are inducted into a major market index, there is a lot of buying in those stocks and they usually outperform the market in the short run.

This interest is sparked by the mutual funds rebalancing their portfolios to reflect the new entrants' weights. But it often gains a momentum of its own. Maruti, ONGC, Bharti Tele and Zee are all likely to benefit from that momentum.