Market indices are a hypothetical basket of securities, which provide a relevant snapshot of a given market segment. The value of an index reflects the values of its constituent securities. The index provider uses a well-defined methodology to calculate this value.
From the perspective of the investor, the primary purpose of an index is to offer simple and easy-to-understand exposure to a market or a market segment. The best analogy for a market index is a public opinion survey. While the latter takes all expressed opinions into account in equal measure, indices use mathematical weighting methods.
This way, more important constituents exert a bigger influence on the index value. Some indices have made their methodology public. Others keep the formula that they use under wraps.
Type Of Indices
These are some of the methods used to produce indices:
The simple arithmetic average method worked well back in the early days of market indices. Due to the lack of digital technology, keeping the calculations as simple as possible was of the essence then. Although some indices might still use this method, it is too simplistic to properly address current needs.
To calculate an arithmetic average, one simply needs to add up the stock values of the constituents, dividing the resulting number with the number of constituents.
Price Weighted
The price-weighted average takes into account the actual price per share, rather than other factors.
Some of the biggest/best-known indices use this weighting method.
Market Cap Weighted
Market cap-weighted indices use market capitalization as their weighting factor. Market capitalization translates to the total value of the outstanding shares of an index constituent. It is obvious that market cap is directly impacted by the price per share.
The larger the market cap of an index member, the larger its weight will be in the index value.
Revenue Weighted
The revenue-weighted method breaks free of the limits/shortcomings imposed by stock price. Some consider indices based on this method more relevant conveyors of actual company value. Unlike stock value, revenues cannot be manipulated through accounting practices. And hype does not impact them either.
Float Weighted
Float-weighted indexes use the market cap-weighting method. When determining the individual market caps of constituents, however, they only take “floating” shares into account, rather than all outstanding shares. Floating shares are shares available for trading.
Fundamentally Weighted
Fundamentally weighted indexes look past factors linked to stock price, such as market capitalization. Instead, they rely on fundamental factors such as revenue, book value, earnings or dividend rates.
Such factors offer a better and more consistent picture of the value of an index participant. Thus, such indices might provide a more accurate snapshot of the market segment they represent.
Index Funds
Traders/market participants cannot invest into indices directly.