How are the stocks in the portfolio weighted?

There are basically three types of weighing :

• Market Capitalisation weighted
• Price weighted
• Equal weighted

As may be discerned, the stocks in the index could be weighted based on their individual prices, their market capitalisation or equally.

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 indexes.

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).

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.

Selection Criteria

Most indexes attempt to strike a balance between the following criteria.

• Better Industry representation
• Maximum coverage of market capitalisation
• Higher Liquidity or Lower Impact cost.

Industry Representation

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.

Market Capitalisation

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.

    
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