In our previous article we talked about various types of indices one can create, using different weighting schemes. In this article, let’s understand a sector Index.
As the name suggests, sector index/benchmark tracks the performance of a particular sector. Let’s take the example of BSE AUTO Index. It is used to track the performance of auto sector companies listed on BSE. As discussed in our initial articles on index, an index should comprise companies from each segment of the sector to remove all biases. You can quickly revise our examples of real estate index or IT sector index, for better understanding of the same. In the case of BSE AUTO index, it includes companies from all segments of Auto sector: auto parts manufacturers, tyre manufactures, 4 wheeler manufacturers, 2 wheeler manufacturers etc. The objective of creating the index was to put together the best possible representative sample of auto stocks and then track them all together through an index value. Once a representative sample is selected, generally market cap weighting scheme is used to create indices. BSE Auto index allows us to track the happenings of the Indian auto sector as most of the Indian auto companies are listed on BSE. If we want to see what is happening to Auto sector in Germany or USA, we can follow the auto sector indices of respective country exchanges. We can also create a global auto index by considering all the auto companies listed on various exchanges. A select group of companies that best represent the global auto sector universe can then be short-listed to form a basket.
Let’s consider one more example and talk about Nifty Media Index. It’s a Media sector index and represents media companies listed on NSE. As discussed, first step is to select companies from all segments of the sector to make the best possible representative sample. Nifty Media includes broadcasters, printers & publishers, film production houses and other segments of the Media sector. Once companies are selected, weights are decided based on the market cap weighting methodology. The company with highest market cap will have the highest weight. At the beginning of Jun’15, index value of Nifty Media was 2108. The same value at the end of Jul’15 was 2452. Using this we can quickly say that Media sector generated a return of 16.3% (2452/2108-1), in these two months. Similarly, we can calculate the returns generated by other sectors and compare them with each other to know which sector is performing the best.
Generally, sector indices based on companies listed on BSE, have BSE as their prefix: BSE Auto, BSE IT, BSE Metals etc. Sector indices based on companies listed on NSE, have Nifty as their prefix: Nifty Pharma, Nifty Auto, Nifty Realty etc. Tracking these tailor-made, easy to use indices enables an individual to quickly ascertain a sector’s health, its historical performance compared to other sectors, and helps him make a better investment decision. Let’s now learn and understand about custom indices.