The number of shares issued to outstanding multiplied by the market price of company’s share determines its weightage in the index. The total of market capital of all shares in the index is linked to an index number. The shares with the highest market capitalization are most influential in this type of index.
Examples: S&P 500 Index in the U.S., BSE Sensex and S&P CNX Nifty in India
Modification 1: the number used as out standing shares is adjusted to reflect only those shares that are freely available for trade (floating stock) ignoring those shares which are not expected to be traded in the market (like promoters holding). Example: RUSSEL 100
Modification 2: it seeks to limit the influence of the largest stocks in the index, which otherwise would dominate the entire index this is done by setting a limit on the percentage weight of the largest stock or a group of stocks.
Example: NASDAQ 100
Price Weighted Method
The type of index sums up the price of each stock in the index, which is then equated to an index starting value. The shares with the highest price are not influential in this type of index. If a stock splits, its market price falls resulting in less weight in the index. Examples: Nikkei 225 average of Japanese Stocks, Dow Jones Industrial Average and PSE Technology indices in U.S.
Equal Weightage Method
Each Stock’s percentage weight in the index is equal and therefore all stocks have equal influence on the index movement. Examples; Value line index at KCBT
As may be discerned, the stocks in the index could be weighted based on their individual prices, their market capitalisation or equally.
h)What is the better weighing option?
The market capitalisation weighted model is the most popular and widely considered to be the best way of determining the index values.
In India both the BSE-30 Sensex and the S&P CNX Nifty are market capitalisation weighted indices.
i)Who owns the index? Who computes it?
Typically exchanges around the world compute their own index and own it too. The Sensex and the Nifty are case in point.
There are notable exceptions like the S&P 500 Index in the U.S. (owned by S&P which is a credit rating company) and the Strait Times Index in Singapore (owned by the newspaper of the same name).
j)Who decides what stocks to include? How?
Most index providers have a index committee of some sort that decides on the composition of the index based on standardised selection and elimination criteria.
The criteria for selection of course depends on the philosophy of the index and its objective.
Most indices attempt to strike a balance between the following criteria.
- Better Industry representation
- Maximum coverage of market capitalisation
- Higher Liquidity or Lower Impact cost.
Since the objective of any index is to be a proxy for the market it becomes imperative that the broad industry sectors are faithfully represented in the Index too.
Though this seems like an easy enough task, in practice it is very difficult to achieve due to a number of issues, not least of them being the basic method of industry classification.
Another objective that most index providers strive to achieve is to ensure coverage of some minimum level of the capitalisation of the entire market. As a result within every industry the largest market capitalisation stocks tend to select themselves. However it is quite a balancing act to achieve the same minimum level for every industry.
Liquidity or Impact Cost
It is important from the point of usability for all the stocks that are part of the index to be highly liquid. The reasons are two-fold.
An illiquid stock has stale prices and this tends to give a flawed value to the index.
Further for passive fund managers, the entry and exit cost at a particular index level is high if the stocks are illiquid. This cost is also called the impact cost of the index.
l) What is a benchmark index?
An index that acts as the benchmark in the market has an important role to play.
While it has to be responsive to the changes in the market place and allow for new industries or give up on dead industries, at the same time it should also maintain a degree of continuity in order to survive as an benchmark index.
m) What are the popular indices in India?
- BSE-30 Sensex
- BSE-100 Natex
- BSE Dollex
- S&P CNX Nifty
- S&P CNX Nifty Jr.
- S&P CNX Defty
- S&P CNX Midcap
- S&P CNX 500
n) What are sectoral indices?
These indices provide the benchmark for sector specific funds.
Fund managers and other investors who track particular sectors of the economy like Technology, Pharmaceuticals, Financial Sector, Manufacturing or Infrastructure use these indices to keep track of the sector performance.
o) What are the uses of an Index?
Index based funds
These funds tend to replicate the index as it is in order to match the returns on the market. This is also known as passive management. Their argument is that it is not possible to beat the market over a sustained period of time through active management and hence it’s better to replicate the index.
Examples in India are
- UTI’s fund on the Sensex
- IDBI MF’s fund on the Nifty
Exchange traded funds (ETFs)
These are similar to index funds that are traded on an exchange. They are pretty popular world wide with non-resident investors who like to take an exposure to the entire market. S&P’s SPDRs and MSCI’s WEBS products are amongst the most popular products.