on and actually worsen an index.
Component illiquidity contaminates index
There are three problems: 'stale prices', 'bid-ask bounce' and vulnerability to manipulation. Through these problems, an index is actually worsened when illiquid stocks are put into it.
Illiquid stocks yield bad price data; so the best quality data will come from the most liquid exchange. In India, that is NSE. The NIFTY 50 uses price data from NSE for calculations.
Suppose we look at the closing price of an index. It is supposed to reflect the state of the stock market at 3:30 PM on NSE. Suppose an illiquid stock is in the index. The last traded price (LTP) of the stock might be an hour, or a day, or a week old! The index is supposed to show how the stock market perceives the future of the corporate sector at 3:30 PM. When an illiquid stock injects these 'stale prices' into the calculation of an index, it makes the index more stale. It reduces the accuracy with which the index reflects information.
Suppose a stock trades at bid 1440 ask 1490. Suppose no news appears for ten minutes. But, over this period, suppose that a buy order first comes in (at ₹ 1490) followed by a sell order (at 1440). This sequence of events makes it seem that the stock price has dropped by ₹ 50. This is a totally spurious price movement! Even when no news is breaking, when a stock price is not changing, the 'bid-ask bounce' is about prices bouncing up and down between bid and ask. These changes are spurious. This problem is the greatest with illiquid stocks where the bid-ask spread is wide. When an index component shows such price changes it contaminates the index.
The index is a large entity and is intrinsically harder to manipulate when compared to individual stocks. Obviously, larger indices are harder to manipulate than smaller indices. The weak links in an index are the large, illiquid stocks. These are the achilles heel where a manipulator obtains maximum impact upon the index at minimum cost. Optimal index manipulation consists of attacking these stocks. This is one more reason why illiquid stocks should be excluded from a market index; indeed this aspect requires that the liquidity of a stock in an index should be proportional to its market capitalisation.
The NIFTY 50
NIFTY 50 is based upon solid economic research. A trillion calculations were expended to evolve the rules inside the NIFTY 50 index. The results of this work are remarkably simple: (a) the correct size to use is 50, (b) stocks considered for the NIFTY 50 must be liquid by the 'impact cost' criterion, (c) the largest 50 stocks that meet the criterion go into the index. NIFTY 50 is a contrast to the adhoc methods that have gone into index construction in the preceding years, where indices were made out of intuition and lacked a scientific basis. The research that led up to NIFTY 50 is well-respected internationally as a pioneering effort in better understanding how to make a stock market index. See "Market microstructure considerations in index construction" by Ajay Shah and Susan Thomas, CBOT Research Symposium Proceedings, Summer 1998, page 173-193.
Suppose a stock trades at bid 99 and ask 101. We say the "ideal" price is ₹ 100. Now, suppose a buy order for 1000 shares goes through at ₹ 102. Then we say the market impact cost at 1000 shares is 2%. If a buy order for 2000 shares goes through at ₹ 104, we say the market impact cost at 2000 shares is 4%. Market impact cost is the best measure of the liquidity of a stock. It accurately reflects the costs faced when actually trading an index. For a stock to qualify for possible inclusion into the NIFTY 50, it has to reliably have market impact cost of below 0.50 % when doing NIFTY 50 trades of twp crore rupees.
Earlier, we said that the index assigns weightages to index components, and the weight of a stock is proportional to its market capitalisation. This idea can be applied to buying the NIFTY 50. If you buy all 50 stocks in the NIFTY 50, in correct proportions, that would be called "an index trade".
It is safe to think that the impact cost is 0.1% or 