What goes into creating market indices
Market indices are constructed by putting together securities that are representative of a specific market, segment or theme. For many years, the weighted market capitalisation methodology of constructing indices remained prominent, till the introduction of equal weighted indices in the previous decade and fundamentals based indices after that.
The choice of methodology makes a difference to the performance of the index. Indices are important for any investor because portfolio performances get measured against these indices which are used as benchmarks. For passive investors, entire portfolios are based on indices.
Market cap weighted versus equal weighted
The Nifty 50 index and the S&P BSE Sensex are both popular examples in the domestic market of market cap weighted indices. Each of them represent the top stocks in the market measured by market capitalization. While the former includes 50 stocks in the basket, the latter has 31. In both cases, the percentage representation of each stock is determined according to the its total market cap adjusted for the number of stocks available to the public (free float). What this means is that large companies will have a higher presence in the index and will be a bigger determinant of the overall index performance. As a result, for both indices in the example, the top holding is HDFC Bank.
What impacts performance is the weight of the top stock versus, say, another one lower down the rank. For example, in the Nifty 50, the weight of HDFC Bank stands at 9.6% whereas, the 10th stock, State Bank of India, is at 2.75%. Clearly, any change in HDFC Bank’s stock price will have a greater impact on the overall index price. Moreover, the top 10 stocks constitute slightly over 60% of the weightage; these are the stocks that matter the most; the remaining 40 stocks are not as significant in terms of contribution to performance.
This creates a bias, as an uneven weightage implies that in certain market conditions, large sized stocks that may be overvalued add more to performance than their smaller peers where price appreciation is not happening at the same pace.
Unlike this, an equal weighted index has all stocks in equal proportion and no one stock contributes unevenly to the overall index performance. Experts suggest that such indices tend to outperform market cap weighted indices in the long term.
The Nifty 50 Equal Weight Index, for example, has the same stocks as the Nifty 50 index but in equal proportion which removes any bias contribution to performance.
Diversified portfolios can choose either type of index as a benchmark. Benchmarking against an equal weighted index can also be done by creating active positions in the portfolio; this type of index may be more suited for a passive investment strategy.
These indices are based on some fundamental characteristics of stock selection; for example, valuation based characteristics like price to book value, return on capital employed, and so on. More recently, smart beta indices have gained recognition. These indices incorporate many factors that can lead to better return generation at a lower risk. Some of the factors are fundamental in nature while others can be more technical factors like momentum, standard deviation and so on.
Fundamental and smart beta indices are unique in their approach and each may have a different objective to achieve. They are not suited as general benchmarks for diversified portfolios.