Getting Up To Speed With The Essentials Of Index Construction

Why choose index investing? Yes, the merits of diversification and low cost are usually factored in, though one critical benefit that many do not realize is the transparency that is provided in the methodology of an independent index provider. To understand what goes into the design and methodology of an index, it’s important to note that it’s not a random pick of securities to represent the index’s concept or design. So, let’s skim through some basics of index construction.

Indices offer a wide range of options whereby their calculation methods might vary. Most equity indices are market-cap weighted and float-adjusted, where each stock’s weight in the index is proportional to its float-adjusted market value. Some equity indices are price-weighted indices, in which constituent weights are determined solely by the prices of the constituent stocks in the index. An example would be the Dow Jones Industrial Average®. Then there are equal-weighted indices in which each stock is weighted equally in the index. There can be restrictions placed in the index where certain constituents are assigned a minimum or maximum weight, and this can be applied to sectors as well. A few more to add to the variety are options include leveraged and inverse indices, which return positive or negative multiples of their respective underlying indices, dividend indices, which track the total dividend payments of index constituents, and the list goes on.

A common query among many is how exactly is an index calculated? Is it a simple average, or is there some complex formula that runs that magic number? The key concept to understand index calculation would be the index divisor. In a capitalization-weighted index, wherein the portfolio consists of all available shares of the stocks in the index, the total value will be a large number (e.g., the float-adjusted market value for the S&P 500® is a figure in the trillions of U.S. dollars). Hence, to make it easy, the number is scaled down by dividing the portfolio market value by a factor, usually called the divisor.

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