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  • Usage of Indices
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  • Usage of Indices

Usage of Indices

Traditional use

Traditionally usage of index was restricted to be a market indicator where participants used to gauge the market trend by referencing the index value.

Benchmarking

Fund managers track index values to benchmark the performance of their mutual fund schemes vis-à-vis returns produced by the indices over different period of time. In simpler words, fund manager evaluates if the investment made as part of the active investment strategy. The ‘active investment’ refers to strategy of investment in stocks based on the research initiatives and assessment about the risk-return profile that results into likely pay-off potential at a future date. Active fund manager is generally indifferent about the index or the index constituents. As said earlier, the fund manager needs a tool i.e. an index that matches closely with the investment objective of the mutual fund scheme for measuring the fund performance.

Introduction of index linked products

Market participants soon realized that stock picking was often exposed to a greater risk such as concentration in select few stocks, adverse economic condition for certain sectors etc. In order to limit the possible losses on account of reasons stated earlier, participants perceived index investment as a safe instrument. Index investment brought in diversity across various stocks and exposure to multiple sectors through a single instrument. The first index fund was launched in 1973 by John Bogle (father of index funds) and the fund tracked the S&P 500 index.

Description of various index linked products

Over period of time, several index linked products were introduced in the capital market. They are:

Passive index funds

The objective of creating the passive index funds is to generate the market return. The term ‘market return’ is generally associated with the returns generated by the underlying index. As the name suggests, the fund manager invests passively in all the constituents of an underlying index in the exact proportion they represent in the index. He does not make any discretion in either selection of a stock or asset allocation. Simple rule for him is to ‘Follow the index’. Any changes that are made to the index will be applied by the fund manager to the index funds.

Investors can buy or sell the units of the index funds by approaching the asset management companies (AMCs) or its distributors. Buy or sell of these units is done based on the net asset value (NAV) of the index fund which is declared at the end of the day. As buy/ sell of index fund units takes place based on NAV calculated on end of day basis, investors are generally deprived of taking a benefit of intraday volatility of the index as this units are not available for trading on the stock exchange (can be bought and sold only through an AMC or its distributor).

Exchange traded funds (ETFs)

ETF is a product that is designed to provide additional features that did not exist in the passive index fund. By definition, ETF is an open ended mutual fund scheme that trades like a stock. Unlike the units of the index funds, the units of the ETFs can be bought or sold like any other stock on the exchange. The origin of ETF goes back to the year 1989 when the first ETF showed up in Canada as the Toronto Index Participation Fund (TIP 35). In 1993, first ETF in USA SPDR was launched that was linked to S&P 500 index. Each of the equity ETF tracks underlying index and the fund manager invests in all the securities that form part of the index.

Exchange traded notes (ETNs)

Exchange-traded notes are a type of unsecured, unsubordinated debt security. This type of debt security differs from other types of bonds and notes in that ETN returns are based on the performance of a market index. In case of ETNs, no period coupon payments are distributed and no principal protection exists. ETNs combine the aspects of bonds and exchange traded funds (ETFs). Like ETFs, ETNs are traded on a major exchange during normal trading hours.

Exchange traded derivatives

Exchange-traded derivatives are products listed for trading on public exchanges and consist mostly of futures and options contracts. Exchange traded derivatives contracts are offered on individual stocks, equity indices, commodities, interest rates etc. Exchange-traded derivatives typically have standard contract specifications and exchanges make pricing available on a real time basis promoting transparency. CNX Nifty and CNX Bank indices of IISL are currently traded actively at NSE under derivatives segment. Further, Nifty linked derivatives contracts are available for trading in Singapore (SGX), Chicago Mercantile Exchange (CME) in USA and Osaka Stock Exchange (OSE) in Japan.

Structured products

Structured products are restructured notes usually issued by investment banks that offer exposure to almost any global market sector combined with varying levels of principal protection. Exposure to the global market sector is provided through a benchmark index of respective market. IISL provides a license to structure the product linked to its indices. Similarly, market linked debentures (MLDs) are issued by the non-banking financial companies (NBFCs) in India where return profile is linked to the underlying index.

OTC derivatives

The over-the-counter (OTC) derivatives market refers to a marketplace that is conducted off-exchange. These derivatives are privately negotiated between two parties, compared to listed derivatives traded through an established exchange or other intermediary.

Client category

List of client categories and their usage of indices: Key client categories of indices with regards to introduction of index linked products are given hereunder:

Asset management companies (AMCs) and insurance companies
AMCs create passive index funds and exchange traded funds linked to indices. Similarly, insurance companies create passive index linked products subject to fulfillment of applicable regulatory investment guidelines.
Stock Exchanges
They introduce index linked exchange traded derivatives contracts (index linked futures & options contracts)
Investment Banks (IBs)
They issue structured products where return profile is linked to the underlying index. IBs also offer trading in OTC derivatives contract linked to benchmark indices.
Non-banking financial companies (NBFCs)
Similar to IBs, NBFCs issue market linked debentures where return profile is linked to the underlying index.
Trading members/ FIIS and other Traders
This category of clients subscribes to the index constituent data to support their index-linked trading strategy. Mostly, the trading members, FIIs that are active in trading in index linked derivatives contracts subscribes to the index constituent data.

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