Bourse needs indices on capital gains, dividends

The stock market indicators at Nairobi Securities Exchange (NSE) show a market on the decline between January and September 2019.

Happenings at the stock market mirror what is going on in the wider economy.

The bourse performance is monitored through an index that measures the change in activity - namely, NSE-20 Share Index, NSE-25 Share Index and NSE All-Share index.

NSE-20 share index is the oldest but consists of blue-chip companies.

There are over 60 companies listed at the NSE but changes in only share prices in 20 companies are assumed to significantly capture market changes.

Trading actively

The 25-Share Index includes only 25 companies.  The NSE All-Share Index has all the shares listed at the Nairobi bourse included.

The NSE lays down conditions that a company must meet before it is included in the NSE-20 Share Index.

First, the company must be trading actively as it will not make sense including a low trading firm in the index to track movements.

Secondly, a company must have at least 20 per cent of its shares quoted at NSE and a minimum capitalisation of Sh20 million.

While NSE-20 Share Index focus only on price, the NSE 25 Share Index focuses on the changes in price and number of shares in issue, that is, on capitalization.

The NSE All-Share Index captures the performance of all the companies.

The advantage of an all-share index is that it is realistic. The danger is that it includes non-trading companies that dampen real changes in the stock market.

Because each stock in the NSE 20 share index has a different price, it follows that each stock has a different weight in the index.

During the last four months, the three indices have been on the decline.

Before May 2019, the NSE 20 Share Index was around 2,900 points, currently, it is at 2,400 points, a decline of almost 500 points or almost 17 per cent.

This means if you invested Sh1 million in all the shares at the NSE-20 share index in May 2019, your wealth will be now down to Sh827,500, which is a loss of Sh172,500 over just six months.

The NSE-25 Share Index was around 4,000 points in April 2019 but has declined to 3,500 points in September 2019.

The decline in the two indices is not statistically significantly different. The two indices tell the same story.

The NSE All-Share Index was around 160 points in April 2019 but was now around 147 points, a decline of 8.1 per cent.

This means an investment of Sh 1 million in the shares included in NSE-All Share Index has their wealth reduced to Sh918,750.

Therefore, when the share prices are on the decline, investors are better off investing in the NSE All-Share Index.

However, when the share prices are expected to rise, the returns will be the lowest if you invest by banking on the NSE All-share.

The NSE-20 Share Index and NSE-25 Share Index tell a different story from the NSE All-Share Index. So which index can investors imitate a portfolio maximising wealth?

The index to adopt depends on its role or use and the investor’s expectation about directional change in the market.

If an investor expects the market to be on the decline, then the preferred index will be the NSE -All-Share Index because the losses will be lower.

While if the investors expect a rise in the NSE either the NSE 20 Share Index or NSE-25 Share Index is preferred because the gains will be higher. An index is used to construct a portfolio in markets in which the prices of security equal its values.

In such a market, investors get value for their money.

If the index represents the market, then the index proxy market portfolio, which is typically the best portfolio (investment) because it is fully diversified.

There are two types of investors at the market place, passive and active investors. 

This distinction does set wealth owners against wealth managers. The class of investors who believe the prices reported at NSE are accurate in reflecting the value in shares, merely buy shares in an index and wait and are known as passive investors.

They are passive investors because they merely buy and hold shares, but this lower down their transaction costs.

Wealth managers prefer the active asset-management approach because they believe that by identifying mispriced securities, investors will higher their services at a fee.

 This group sell overvalued securities and buys undervalued securities.

There is evidence out there to show that passive investors outperform active investors.

NSE needs additional market indicators that capture investors’ confidence in the stock market. This calls for a confidence index to measure investors’ willingness to take a chance in the market.

The confidence index is based on bonds and is a ratio of high-grade bond yield to low-grade bond yield, then that signal increases in confidence in the securities market.

The NSE equally needs volatility index to capture a change in market risk.

The market requires a total return index that takes into account both capital gains and dividend income.

 In all the three NSE indices tell us that currently, the stock market is at its lowest the investors.

Therefore, if there is no default risk, it is time to take advantage to take the low prices at NSE.

-The writer teaches at the University of Nairobi