– By Gyan Anand, T. A. PAI MANAGEMENT INSTITUTE, Manipal
“Sir, our scheme has beaten the nifty year on year”
“Our fund manager has a reputation for generating regular alpha”
Claims as these by investment firms, mutual funds, or insurance providers are regularly seen. The clients often fall for it as they see these claims as something done right by the managers.
However, there exists a catch to this, general understanding. The aim of this paper is to remove the exploitation done, using such claims by companies.
The practice of using a set of stocks to represent the performance of the market was started by Charles H Dow, a financial journalist in 1896, who built the first stock market index The Dow Jones Industrial Average, which was an average of the top 12 stocks in the market. This index was calculated by taking all of the stock prices, adding them together and then dividing them by the number of stocks.
The methodology has changed with the passage of time but the true sense of the index remains intact. Today almost all the major indexes in the world are price indexes, including likes of S&P 500, Nifty, Dow Jones, NASDAQ etc.
The index provides a benchmark against which performance of various investment opportunities is measured. It is a tool which is put to use by investors, financial managers and the likes of them to describe the market and measure performances and returns on various instruments. For instance, mutual funds create portfolios which are actively managed by portfolio managers. When an investor needs to measure which mutual fund has better performance, he needs a benchmark, this is where the ‘Indices’ come in handy. Since an index is a mathematical construct it cannot be traded directly, so various instruments try and imitate the index and if possible beat it (generate alpha).