An index is group of stocks designed to reflect the performance of a market, or a portion of a market (e.g. an industry sector).
When first established, an index can start at any value. Investors track the change in the value to see market movements rather than the value itself.
An index is generally comprised of a portion of the overall universe of stocks in a geography, business sector or other grouping. Commonly referred to as “benchmarks” the index reflects a market’s performance.
Indices are typically named to reflect the:
- Index creator/owner
- Specialisation (geography, business sector, grouping)
- Number of stocks in the index, e.g. Bats UK 100 index
Mathematics and methodology behind an index
The methodology for calculating an index varies and is proprietary to each index creator/owner. A number of rules are required to ensure the index value is only affected by the change in the value of the individual stocks.
For instance, the performance of larger companies has a greater impact on the value of a market capitalisation weighted index than smaller companies.
An index is reviewed on a regular basis to ensure it remains representative of the relevant market. Upon review, known as a rebalance, constituents can be removed and replaced by companies that better reflect the overall market.
The frequency of rebalances varies by index, whilst all are rebalanced on an annual basis, many are also rebalanced on a quarterly basis.
A company is considered eligible to be an index constituent if it meets the criteria stipulated in the index’s rules.
Such criteria can require the company to have a minimum market capitalisation, to have listed a minimum percentage of its shares (its free float), and to possess a minimum level of trading liquidity.