Index Construction Methodology

Index
•What is an index?
Generally speaking, an index is an indicator or measure of something.
 In simple terms, in the world of investing, an index is a hypothetical
portfolio of securities designed to represent an asset class, market, or market
segment.
•How indexes are used
•Indexes play an important and informative role at every step of the investment
process.
•Indexes are used to
analyze economic trends, and investors make decisions based on economists’
forecasts.
to conduct risk analysis, develop investment policies, and create asset allocation
strategies.
The index
The Index The Exchange Weighting Stock included
FTSElOO London Stock Exchange Value 100 largest stocks
Weighted
DAX40 Frankfurt Exchange Value 40 largest stocks
Weighted
NIKKE1225 Tokyo Stock Exchange Price Weighted 225 largest stocks
DOWJONES INDUSTRIAL New York Exchange Price Weighted 30 largest stocks
AVERAGE
NYSE Composite New York Stock Value More than 2000 largest stocks
Exchange Weighted
NASDAQ Composite NASDAQ Value weighted Almost 5000 stocks
CAC Paris Exchange Value weighted 40 largest stocks
S&P 500 NYSE & NASDAQ Value weighted 500 largest stocks
Types of index

1. Price Weighting Index-PWI

2. Market Value Weighting Index-MVWI

3. Unweighted or Equal Weight

Price Weighting Index-PWI
  Aprice-weighted index is a type of stock market index in which each component of
the index is weighted according to its current share price.
In price-weighted indices, companies with a high share price have a greater weight
than those with a low share price. Therefore, the price movements of companies with
the highest share price have the largest impact on the value of the index.
Nowadays, price-weighted indices are less common than other indices. Instead, the
capitalization-weighted index is the most prevalent form of market indices.
 The biggest price-weighted indices are the US Dow Jones Industrial Average
(DJIA) and Japan’s Nikkei 1225.
A price-weighted index is often criticized because it considers only the price of each
component as the driver of the index value. Therefore, even a small price fluctuation
in a higher priced company may significantly affect the value of the index.
Price Weighting Index-PWI
   How to Calculate the Weights in a Price-Weighted Index
• The weight of a individual component is calculated by dividing its price by
the sum of all the components’ prices.
• Mathematically, it is expressed in the following way:
Price Weighting Index-PWI

• Let’s consider the following example.

Stock Price
Company Ticker
2 Jan 2018 13 April 2018
Google GOOGL 1073.21 1,037.29
Facebook FB 181.42 163.87
Apple AAPL 172.26 174.14
Tesla TSLA 320.53 294.08
Microsoft MSFT 85.95 93.58
Price Weighting Index-PWI
The sum of all prices is 1,833.37 and there are 5 stocks.(for January)
The easiest way to create an index is to divide the sum of all stock prices by 5 and you get a
value of 366.674 (=$1,833.37/5).
 This is the starting value of your index.
On 13 April 2018, your index value would be worked out as follows:
Index (13 Apr 2018) =1,762.96/5= 352.592
If you want to start off the index with a value of 100, you must set the divisor different from
5 at time 0 i.e. 2 January 2018.
 The divisor to get you time 0 index value of 100 would be:
Divisor =1,833.37/100= 18.337
• An index divisor is a standardization figure used to compute the nominal value of a price-
weighted market index.
• The divisor is used to ensure that events like stock splits, special dividends, and buybacks do
not significantly alter the index
• The divisor must stay the same unless there is a stock split.
 The index value on 13 April 2018 based on starting value of 100 would be:
Index (13 Apr 2018) =1,762.96/18.337= 96.159
What is index Divisor
• is a number by which the total value of an index is divided to arrive at the
initial market index.
• The Index Divisor does not change frequently, and it also helps in
arriving at the intended easy value of the market index.
• The Index Divisor is significant as the total value of the index will be a
large number.
• This divisor remains constant over time, except in the case of significant
material changes.
• Stock market changes are reflected in the value of the market index.
• If the total value of the index changes, the divisor will be used with a
new number. Therefore, the new value of the market index will arrive.
Price Weighting Index-PWI
• The percentage movement in both cases is the same i.e. a drop of 3.84%.
Comparing the index drop with the drop in individual stock prices, you can see
that the stocks with index return is skewed towards the company with highest
stock price i.e. Google.
Stock Price
Company Ticker Return
2 Jan 2018 13 April 2018
Google GOOGL 1073.21 1,037.29 -3.35%
Facebook FB 181.42 163.87 -9.67%
Apple AAPL 172.26 174.14 1.09%
Tesla TSLA 320.53 294.08 -8.25%
Microsoft MSFT 85.95 93.58 8.88%

•This is because Google has a disproportionately higher weight in the index, i.e.
58.53% and 58.83% at 2 January 2018 and 13 April 2018, respectively.
Market Value Weighting Index-MVWI

A Market Value Weighted Index (MVWI) is the most common type of stock
market index whereby the participants are weighted according to the size
(market cap) of the company.
 Examples of such an index include the S&P 500, NASDAQ, and FTSE
100.
 In such an index, the market capitalization of a stock is determined by
multiplying the market price of this stock by the number of outstanding stocks.
In an MVWI, the stock with a larger (smaller) market capitalization will have a
greater (smaller) impact on the changes or movements of such an index, even if
its absolute price is lower.
 Therefore the largest companies in S&P 500 (based on market capitalization)
will have the greatest influence on this index’s price performance.
Market Value Weighting Index-MVWI

•  Below is a hypothetical market cap-weighted index that includes five constituents.

STOCK STOCK PRICE SHARES MARKET VALUE INDEX

NAME WEIGHT
A $3 50 $150 15%
B $1 50 $50 5%

C $7 70 $490 51%

D $9 20 $180 19%

• When an
E index$10
is first created, a starting (base)
10 value is chosen.
$100 10%
TOTAL MV $970 100%
• In our example, we will use 100 as the base value.
• Now that we have the total market value of our index and our base value, the next step is to determine
the index divisor by dividing the total market value of the index by the base index value of 100 ($970 /
100 = 9.7).
• Each day, as the market values of the stocks in the index fluctuate based on changes to their prices, the
new total market value of the index is divided by the same divisor (9.7) to produce a new index value:
Value Weighting
DAY INDEX TOTAL MARKET VALUE DIVISOR   INDEX VALUE
Day 1 $970 9.7   100.0
Day 2 $1010 9.7   104.1
Day 3 $995 9.7   102.6
Day 4 $1000 9.7   103.1

• The divisor remains constant until the index constituency changes. For example, if a stock is
delisted or a stock split occurs, the divisor will be recalculated to be reflective of the new
index membership.
•How are index values used to calculate performance?
•Index performance between any two dates can be calculated by dividing the ending index
value by the beginning index value as follows. Using our hypothetical index as an example:
•Day 1 index value = 100.0
•Day 4 index value = 103.1
•((103.1 / 100) -1) x 100 = 3.1%
Equal weighting

•The third variation of weighted indexes is the unweighted index; some call it
the "equal-weighted index." All stocks, regardless of share volumes or price,
have an equal impact on the index price. The price change in the index is based
on the percentage return of each component.
•Suppose there are three stocks in our unweighted index example: ABC, XYX,
and MNO. Regardless of how many shares you have of each stock or the actual
trading price, look at the percentage of price movement. So if ABC is up 50%,
and XYZ is up 10%, and MNO is up 15%, the index is up 25% = (50+10+15) /
3 (the number of stocks in the index).
•This is based on an arithmetic average. But some unweighted indexes will use
a geometric average calculation as well. So then the formula would change to
(1.5 + 1.1 + 1.15) [1/3].
What Considerations Investors take for choosing an index?
What Considerations Investors take for choosing an index?

ATTRIBUTE RATIONALE

Since the goal is to gain access to a particular market or

market segment, the index should aim to be as representative
Representative  of this market segment as possible. 

Transaction costs are incurred by passively managed

investments when changes to the underlying index
constituents and weights are made.
It is important that the index balances its goal of being
representative with the need to keep turnover costs
Cost efficient manageable.
What Considerations Investors take for choosing an index?
ATTRIBUTE RATIONALE
Because the investment is replicating the index, it is important that
the rules that govern the index design and calculation are published
openly and transparently.
The investor should be able to understand and anticipate changes to
Objective and the index. If not, replicating the index can be difficult and unintended
transparent tracking errors may occur. 
The index should limit its holdings to those readily available to the
investor. For example, index weights should be calculated using
float-adjusted market cap, meaning the index should only include the
shares that are freely available for purchase by the average investor
rather than those held by employees or other investors who are
Investable restricted from selling their shares
Key takeaways from this Section
An index acts as a barometer of the whole economy
An index going up indicates that the market participants are optimistic.
An index going down indicates that the market participants are pessimistic
Index can be used for a variety of purposes – information, bench marking,
trading and hedging.
 Index trading is probably the most popular use of the index
There are sector specific indices which convey the sentiment of specific sector