y fund should obtain returns like the overall stock market index. A 50:50 debt:equity fund should obtain returns close to those obtained by an investment of 50% in the index and 50% in fixed income. A well-specified relationship between an investor and a fund manager should explicitly define the benchmark against which the fund manager will be compared, and in what fashion.
The most important type of market index is the broad-market index, consisting of the large, liquid stocks of the country. In most countries, a single major index dominates benchmarking, index funds, index derivatives and research applications. In addition, more specialised indices often find interesting applications. In India, we have seen situations where a dedicated industry fund uses an industry index as a benchmark. In India, where clear categories of ownership groups exist, it becomes interesting to examine the performance of classes of companies sorted by ownership group.
Yes, the averaging that takes place in an index is equivalent to diversification. Diversification cancels out individual stock fluctuations. From an investment perspective, diversification reduces risk. From an information perspective, diversification cancels out stock noise; the only thing left after good diversification is the common factor -- news such as nuclear bombs -- which hits all stocks and cannot possibly be removed by diversification.
It is, indeed, the case that putting more stocks into an index yields more diversification. However, two things go wrong when we do this too much: First, there are diminishing returns to diversification. Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Hence, there is little to gain by diversifying, beyond a point. The more serious problem lies in the stocks that we take into an index when it is broadened. If the stock is illiquid, the observed prices yield contaminated information 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. Thi