By Anand Nevatia
An index tries to measure the returns generated by a defined asset class, by taking a number of securities which represent some elements of the total. An index provider may possibly employ numerous principles and criteria for picking out the securities in an index.
The fixed earnings indices in India are largely Liquidity Based i.e. the indices are calculated basis the current liquidity of the issuers. Thus, if an issuer has witnessed a higher principal or secondary marketplace volume in a quarter, they get preference in terms of inclusion and weightage, in the subsequent rebalancing of the index.
As a outcome of this method, the index could see a lot of churn in the constituent securities on just about every rebalancing due to a alter in the liquidity profile of the issuers. Fund managers who adhere to the benchmark allocations would have to trade more, major to improved transaction fees to the fund, thereby impacting its returns. Another drawback could be in a predicament wherein a new issuer is in a position to obtain substantial weightage in the index based on activity based parameters. Liquidity could conveniently dry up in an untested new issuer, thereby forcing all index funds to liquidate in an illiquid marketplace.
The biggest fixed earnings indices across the world are not topic to these inefficiencies, as they are constructed utilizing the Broad-Based method. These indices take into account the total outstanding issuance quantity of the issuers, i.e. larger the quantity outstanding, the larger will be the weightage.
The Broad-based method has particular essential benefits more than the Liquidity Based method:
Characteristics
– More correct representation of the underlying universe
– Relatively decrease churn
– Inherently liquid portfolio
Benefit to Investors
– Returns are more commensurate to the underlying asset class
– reduces transaction and effect fees hence major to larger returns
– Mitigates liquidity threat more than a period of time
Below are a handful of examples of substantial fixed earnings indices that adhere to the Broad-Based Concept
A essential element of the investment procedure is the Model Portfolio which is constructed based on the Broad-based method. The model portfolio is constructed in two stages:
1. Category allocation: The sector weights are assigned basis their total outstanding. For instance, say PSU Financial Institutions category has 20% of the total outstanding so in the initial composition the weightage is set to 20%.
2. Issuer allocation: Within categories, weights are then assigned to person issuers basis their total outstanding issuance quantity
The weights to categories and issuers are then adjusted for regulatory compliances. Thereafter, periodically the model portfolio is rebalanced to take into account any modifications in the underlying universe.
The aim of adopting a broad-based method in fixed earnings investing is to provide investors constant threat adjusted returns that are commensurate to the underlying asset class by means of a structured and transparent investment procedure.
(Anand Nevatia is Fund Manager at Trust AMC. Views expressed are the author’s personal.)