How to Invest in Stock Indices

Is it possible to invest in stock indices? Stock index investment does not look practical since the closest you can get is to buy all the components of the index in the same proportion as the index. But there are smarter ways of stock index investment. For example, it is possible to buy an index fund that replicates. Another way of stock index investment is to buy an index ETF or exchange-traded fund that replicates the index. The third way of stock index investment is through derivatives like swaps, index options, and index futures.

The moral of the story is that, even though the index itself is abstract, there are methods of stock index investment by the use of proxies. Let us look at this in greater detail.

How to Invest in Indices?

What exactly is the definition of an index. You can look at an index as an imaginary portfolio of securities representing a particular market or a portion of it. For example, the Nifty is representative of all the large high-value stocks in the market. The NSE mid-cap index is a barometer of mid-sized companies on the NSE. The NSE auto index is a barometer of all the automobile-listed stocks on the NSE. The list can go on. The same logic applies globally too.

How to invest in indices? Is it possible to buy a stock index investment? While you cannot buy indexes, there are three methods or instruments you can leverage to replicate an index investment or mirror a stock index investment.

Firstly, you can just replicate the index

This is popularly known as indexing. Here, you effectively create your portfolio of securities that best represents an index, such as the Nifty or Sensex. The stocks and the weightings of your allocations would be the same as in the actual index. But this is a tedious and complex process and it is tough to buy the index as a basket at a single point in time. Hence you could see spillages resulting in a higher cost of purchase.

A very common method of index investing is a variant of indexing as above but it is called the Smart Beta approach. What exactly is this smart beta approach. It is essentially an attempt to amplify the returns of an underlying portfolio or index while minimizing tracking error. This is somewhere between being entirely active and entirely passive. Unlike basic indexing, smart beta tries to beat the index.

Index Futures and Options

This is a slightly trickier way of investing in an index and can be riskier than pure indexing or buying ETFs as we shall see later. If you are active in the F&O segment, you can buy index futures or index options. For example, in India, the Nifty futures and the Bank Nifty futures are extremely liquid and you can buy them as proxies for the index with a limited chance of error or spread the cost. You can also buy options of at the money or slightly out of the money strikes to replicate the index. This is an accepted strategy of indexing.

Index futures allow the trader to buy or sell a financial index today to be settled at a future date. Index futures can be effectively used to speculate on the direction of price movement for an index such as the Nifty or Sensex. But ideally, this is used to hedge index risk in the market or to hedge a portfolio of stocks. The other method is to buy index options and index options in India are extremely liquid. Index options are financial derivatives that give the contract holder the right, but not the obligation, to buy or sell the underlying index. All futures and options contracts come with expiry dates and are cash-settled only in India.

Index Mutual Funds

A very important method of buying the index is via index funds. Today most of the mutual funds in India offer index funds benchmarked on the Nifty or the Sensex. These are typically funds with low tracking error and mirror the index pretty well. The risk is low and costs are also low.

Exchange-Traded Funds or ETFs

Exchange-traded funds (ETFs) track an underlying asset and are split into tradable units and traded in real-time. Unlike index funds that only give day-end purchase and redemption prices, the ETF gives real-time buy and sell prices on the indices. ETFs are lower in cost scale than index funds also and can be used to replicate an index. Remember that both index funds and ETFs are designed to mimic the marketplace or a sector of the economy and require very little active management. At the same time, these index funds / ETFs also offer diversification at a much lower cost.

Differnet Instruments to Invest in Stock Indices

Investing in stock indices using a stock market app is called passive investing, and there are several instruments to facilitate such passive investments in the index. Here is a summary of the stock index investment instruments. Remember that passive management can be achieved through holding the following instruments or a combination of the following instruments.

1. First and foremost, you have the Index funds, which are nothing but mutual funds that try to replicate the returns of an index by purchasing all the securities underlying the specific index in the same proportion. Some funds even try to replicate index returns through sampling. Normally, a good index fund must track the index returns with a low tracking error

2. Secondly, there are the all-important and popular Exchange-traded funds or ETFs. These ETFs are open-ended, pooled, registered funds traded on a recognized stock exchange with a unique ISIN. Such ETFs can be held in your Demat account just like any other stock and represent proportionate unit ownership. There is a dedicated fund manager for the underlying portfolio of the ETF much like an index fund. These units of ETFs entail market making at the back-end.

3. Index futures contracts are a derivative bet on the movement in the price of a particular index. Stock market index futures offer investors multiple advantages. They offer easy trading, the ability to leverage through notional exposure, and zero management fees. However, futures contracts expire, so they must be rolled over periodically and this rollover has a cost implicit to it. Also, futures entail MTM margins regularly and the trader must be prepared for the same.

4. Alternatively, the trader can look at index options on particular indices. In India, the options on Nifty and Bank Nifty are extremely popular and also liquid. Options offer investors asymmetric payoffs in that they limit the risk of loss for the buyer but make it unlimited for the seller of the option.

5. Stock Market Index Swaps are yet to take off in India but are quite popular globally. They are normally over-the-counter or OTC contracts where you are allowed to swap a portfolio for an index or swap one index for another index or one market for another. The meaning of swap is an exchange.

Advantages of Investing in Stock Indices?

Let us now look at some of the major advantages or merits of investing using the index route.

• It is tough to beat the market and that has been proven time and again. Nearly 80% of the fund managers struggle to beat the markets in most of the developed markets and India is getting there. Indexing offers a much simpler and more reliable solution for such situations.

• Index investing helps to substantially reduce costs. Passive investing generally costs around 0.20% a year in fees, compared to around 1.75% percent for active investing. Over a longer time frame, this kind of cost-saving can make a huge difference to your returns on investment. This is more so in competitive markets.

• You don’t worry about churning your portfolio as that is done by the ETF or index fund. This minimizes your tax outgo. Also, you are always in sync with the index which is not possible if you index on your own. Unlike in active investing, there is pressure to beat the market, just to reduce the tracking error.

• Above all, passive or index investing is about discipline. Relying on the inherent strategy of an index fund puts an arm’s length distance between you and the trading decision. This makes your investment process more disciplined and dispassionate.