| FAQ's about Indexing: |
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What does an index signify? |
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What are the various markets for which index can be constructed? |
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What should a Stock Market Index capture? |
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What do the ups and downs of an index mean? |
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What is the role of an ideal index? |
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What is the formulae for calculating Index? |
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Does the weightages of the constituents of the index keeps on changing? |
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In what cases Base divisor of the index is changed? |
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How Base adjustment to the index is carried out? |
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What are uses of an index? |
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What kinds of indices exist? |
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Isn't averaging like diversification; cancelling out vulnerability to one stock? |
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Then all the stocks should form part of the index? |
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Does revision of index affects the index figures? |
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Does revision in index composition is actually required? |
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What are the different types on which indices can be constructed? |
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What are the most useful methods for construction of index? |
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What is free float? |
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Why free float methodology is considered as the best methodology for index construction? |
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How are free float factors of the company determined? |
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| What does an index signify? |
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| An index in general means a barometer of the underlying universe comparing the underlyings over two periods showing various ups and down in the underlying market. Indexes are generally used to track and judge the markets. The ideal index should give us the expectations of the market behavior. |
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| What are the various markets for which index can be constructed? |
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| Index can be constructed for various underlying markets for capturing the behavior of any financial markets like Stock Markets, Commodity Markets, Currency Markets etc. |
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| What should a Stock Market Index capture? |
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| A stock market index should capture the general mood of the overall equity market as a whole. Movements in the index should represent the true behavior of the economy and country as a whole. |
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| What do the ups and downs of an index mean? |
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| The ups and down in the index reflect the changing expectations of the stock market about future growth prospects of the economy in general and corporate sector in specific. There are many macro factors of the economy like GDP growth rate, average industrial production growth rate, investment and consumption pattern in the country etc. on which the market behaves. On the other hand an index is also affected due to company and sector specific news like future earnings, dividend expectations of the shareholder, outlook of the sector in which the company is operating. |
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| What is the role of an ideal index? |
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| The movement in stock prices is generally for three possible reasons i.e company specific news (decrease in production, closure of factory etc.) sector specific news (change in tax structure for the sector) and economy related news(terrorist attacks, government fallout etc) . The job of an index is to purely capture the third part, i.e the movements of the stock market as a whole (i.e. news about the economy as a whole). This is achieved by sector balancing and principle of averaging. An ideal index gives representation to all major significant sectors of the economy and hence any news about the company in the sector is offsetted by the news of other company in the same sector. Similarly any sector specific news is neutralized by other sector news. Hence what remains is economy related news and an ideal index should represent that only. |
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| What is the formulae for calculating Index? |
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| Index Calculation Formulae: |
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Where Market Cap = Number of outstanding shares x Price
Base index number is a starting index number used for reference point.
Base Market capitalization (also called as Base divisor) is the number which is adjusted for each and every corporate action of the constituent of the index to maintain the continuity of the index values. |
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| Does the weightages of the constituents of the index keeps on changing? |
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| Yes, the weightages of the index constituents keeps on changing as they are weighted according to the market capitalization and market capitalization is the function of price and shares and prices keeps on changing every moment. |
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| In what cases Base divisor of the index is changed? |
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| Any addition or deletion of scrips in the index, change in free float factor of the existing constituent of the index, change in equity of the company leading to change in market cap of the company like rights issue, New issues of shares like ESOPs, preferential allotments, conversion of debentures, warrants, ADRS/GDRS, FCCBs into equity shares of the company, buy back etc. In short whenever the listed equity of the company is changed appropriate effect to the base market capitalization of the index will be given. |
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| How Base adjustment to the index is carried out? |
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By applying the following formulae base adjustment is carried out in the index. |
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| To illustrate, suppose a company issues right shares which increases the market capitalisation of the shares of that company by say, Rs.100 crores. The existing Base Market Capitalisation (Old Base Market Capitalisation), say, is Rs.2450 crores and the aggregate market capitalisation of all the shares included in the index before the right issue is made is, say Rs.4781 crores. The "New Base Market Capitalisation " will then be: |
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| What are uses of an index? |
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| Generally indices are used to track the pulse of the markets, to capture the behavior or the mood of the economy. But Indices can also be used in financial markets to launch Exchange Traded Funds on the indices, to have Futures and Options available on the index. Also Passive and Active style of investing is possible with Indices like a specific fund can be lauched on any index (passive style of investing) or index can be used as a benchmark for comparision purpose (active style of investing). |
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| What kinds of indices exist? |
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| The most important type of market index is the broad-market index, consisting of the large, liquid stocks of the country. In most countries, a single major index dominates benchmarking, index funds, index derivatives and research applications. In addition, more specialised indices like segment indices (Large cap, Mid Cap, Small Cap, Micro Cap) and Sectoral Indices (Auto, Telecom, Capital Goods, Banking) are also available. |
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| Isn't averaging like diversification; cancelling out vulnerability to one stock? |
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| Yes, the averaging that takes place in an index is equivalent to diversification. Diversification cancels out stock and sector specific news; the only thing left after diversification is economic news which affects all companies in the same way-such as political instability, terrorist attack etc. |
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| Then all the stocks should form part of the index? |
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| The case of putting all or more stocks into an index yields more diversification. But the case against putting all stocks in an index is there are diminishing returns to diversification. Also if illiquid stocks form part of the index it actually affects the quality of the index. |
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| Does revision of index affects the index figures? |
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| No. by applying the above base adjustment mathematical formulas, continuity in the index level is ensured and yesterday's value and today's value are comparable, even if a change in composition takes place in-between. |
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| Does revision in index composition is actually required? |
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| Yes, to keep the indices meaningful, revision in composition of indices is actually required. Many new hugely market capitalized and liquid stocks do get listed in the stock exchanges, and keeping them out of the index doesn't serve the purpose of an ideal index. Similarly, existing constituents of the index if under-perform and doesn't satisfy the scrip selection criteria then they make way for better and quality stocks to be included in the index. Hence, to show the correct and true representation of the market the composition of the index is reviewed on a regular basis. |
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| What are the different types on which indices can be constructed? |
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| The different methodologies on which indices can be constructed are price-weighted index, equal weighted index, capped index, full market capitalization index, free float market capitalization index. |
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| What are the most useful methods for construction of index? |
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| Full Market capitalization and free float market capitalization index are most widely used and tracked indices all over the globe. Free float indices are globally accepted methodology for construction of indexes. |
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| What is free float? |
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| Free float refers to that number of shares which are available freely for trading in the market. Promoters holding, any lock in shares, strategic holding are not considered as free float. Shares available with institutions, mutual funds, general public are generally considered as free float shares. |
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| Why free float methodology is considered as the best methodology for index construction? |
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| A Free-float index reflects the market trends more rationally as it takes into consideration only those shares that are available for trading in the market. Free-float Methodology makes the index more broad-based by reducing the concentration of top few companies in Index. A Free-float index aids both active and passive investing styles. It aids active managers by enabling them to benchmark their fund returns vis-à-vis an investible index. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best suited for the passive managers as it enables them to track the index with the least tracking error. |
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| How are free float factors of the company determined? |
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| To determine free float factor of the company, promoters holding, lock in shares, subsidiary companies or sister concern's holding, strategic holding is reduced from the total holding of the company. |
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