## Thursday, May 31, 2007

### Derivatives on Nifty Junior and CNX-100

When Nifty was done a long time ago [link], the key insight was that for an efficient futures market, it should be easy for arbitrageurs to force the futures towards fair price. This requires low impact cost (IC) when doing basket trades for the index. Low impact cost for doing basket trades for the index also helps other applications of an index, such as index funds.

Nifty futures were launched in mid-2000 and from 2001 onwards, the Nifty derivatives market did pretty well. The 9/11 attacks were of decisive importance in getting many stock market participants to shift their gaze away from individual stocks to the overall index.

Nifty Junior is the second tier: of stocks which don't make it into Nifty. For the rest, it's the identical methodology as that in Nifty. The methodology ensures that Nifty and Nifty junior have no common members. CNX-100 is the not-so-nifty name that's been given to the merged index of all 100 stocks. It's the index of the top 100 liquid stocks of India.

### How Nifty Junior is different

The most interesting feature of Nifty Junior has been the remarkable returns over the last 10.57 years (the data starts from 4 November 1996). While Nifty returned 4.82 times (16.04% per year) over this period, Nifty Junior returned 8.1 times (21.89% per year) over the identical period. When many actively managed mutual funds talk about outperforming Nifty, it has to do with their loading up on Nifty Junior risk.

Over the last 10.57 years, you could have got a 21.89% return per year (not counting dividends) while paying 25 basis points to an index fund manager. Imagine that. If you use ETFs, you can replace the (big) cost of the mutual fund agent / distributor with the (small) brokerage fee.

Where did these wonderful returns come from? The CNX-100 (total return) index went from 1000 on 1-1-2003 to 4576.6 today, while the P/E went from 14.04 to 19.75. So there was a 1.4x gain owing to improved P/E, and a 3.25x gain in net profit, multiplying up to the overall 4.5766 times return. The bulk of the story was in the growth of net profit.

Current valuations for the three indexes are:

 Feature Nifty Junior CNX-100 P/E 20.11 17.78 19.75 P/B 5.59 4.02 5.30 Dividend yield (%) 1.1 1.06 1.1