How Are Indices Calculated & Constructed?
Indices are diverse assets created and used for a variety of reasons. Learn how they're compiled and calculated to strengthen your knowledge of index trading and shape better analysis and decisions.
Indices provide convenient exposure to entire markets or segments, yet their inner workings can be highly complex. Read our market guide to unpick them as we cover:
- Why are indices created?
- Who compiles indices?
- How are indices created?
- How are indices calculated?
- Base values and divisors
- Price return vs total return
- The problem with comparing index values
- How are indices maintained?
- How this knowledge can strengthen your trading
Why are indices created?
Indices are independent, transparent financial tools for measuring the performance of groups of securities, helping you monitor how broader markets and segments perform over time. These markets can be defined in many ways; for example, focusing on regional, industry or thematic securities.
An index indicates the health and direction of such a market using real-time information about the securities comprising it. They act as performance benchmarks for investors, as well as informing index-linked financial products that track them.
All kinds of people use indices as research and analysis tools, from economists to institutional investors and retail traders like you.
Who compiles indices?
Indices are created, calculated and maintained by index providers. These are specialised firms not dissimilar from software companies in that they create, license and deliver IP-based digital products with relevant support. Crucially, index providers are impartial.
Indices need to be strategically and objectively composed, rigorously maintained and publicly distributed to offer reliable value. They must provide market measurements rather than forecasts, and benchmarks instead of advice. Index providers don't directly sell investment products either; they license indices that underly them. And they don’t manage money.
Major index providers include S&P Dow Jones Indices, MSCI and FTSE Russell.
How are indices created?
The way indices are first created can vary between index providers but generally follows these steps:
1.Defining index scope
Every index begins with an idea that must be shaped into a clear and useful purpose based on the market, asset class or strategy it will measure.
Securities can include stocks, bonds, commodities, real estate, currencies and more. Index providers can then narrow this down to a subset, such as country or industry-based stocks with certain characteristics.
This underlying market is sometimes known as an index universe or exposure.
2.Developing inclusion criteria
Next, index providers create a set of rules on what is eligible for inclusion. They must be methodical and free of subjectivity, including all practical opportunities available, as well as allowing for the evolution of markets over time.
Index criteria may be based on factors such as:
- Market capitalisation
- Location – for example, company stocks with headquarters in the US
- Whether securities are available for public trading (not private companies, for example)
- Liquidity and how frequently securities are traded
With eligible assets identified, index providers usually rank them and include only the top qualifiers. The FTSE 100 index, for example, measures the performance of the 100 largest eligible companies on the London Stock Exchange. Index rules and methodology are usually made publicly available – typically on the provider's website – for full transparency.
Next up is calculating how an index is balanced and valued.
How are indices calculated?
The first documented index, the Dow Jones Transportation Average launched in 1884, provided a simple market average of the 11 companies it tracked. But the value of modern indices can now be calculated in three main ways, based on data-driven mathematical rules around each security's relative influence.
These values are calculated and published daily, either after market close or in real time. Any change in value represents the performance of the index and the market or segment it's intended to measure.
1. Price-weighted
These indices weigh constituents based on share price, giving greater influence to securities with higher prices. Changes in the share price of higher-weighted securities have more impact on the overall index than those of lower-weighted securities.
The Dow Jones Industrial Average is one of the most prominent examples of a price-weighted index.
2. Market-capitalisation-weighted
These indices weight securities based on market capitalisation, which is calculated by multiplying share price by the number of publicly available shares. Companies with a larger market cap are granted greater weighting and impact on an index.
Float-adjusted market-capitalisation-weighted indices are most common. This variation represents a security's size based on the number of shares available for public trading, excluding non-public shares.
The DAX is a popular example of this methodology, tracking the 40 largest companies listed on the Frankfurt Stock Exchange.
3. Unweighted
Unweighted indices are just as they sound, giving equal influence to all constituents and limiting the impact of single assets over others. There is market demand for this unbiased approach; there's an equal-weight version of the S&P 500, for example.
Base values and divisors
Indices are given a starting value when first created, known as the base. After calculating the total index value through one of the methods above, an index divisor is then determined by dividing this market value by the base value.
As the market value of an index's constituents fluctuates over time, the total market value is always divided by this same divisor to calculate new index values. Divisors remain constant until any index rebalancing takes place; read more on this below under 'how are indices maintained?'.
Price return vs total return index values
Index values can also be calculated as price return or total return:
- Price return value measures changes in index security prices and market values over time.
- Total return measures the same data points as well as accounting for dividends paid to shareholders by reinvesting them. This reinvestment takes place at index level, rather than for individual securities.
The problem with comparing index values
Sometimes multiple indices are created to measure the same or similar markets, yet there's little use in comparing their overall values. Indices can be launched at different points in time and with different base values and divisors, making their overall values incomparable.
What holds more relevance is their comparative growth or decline in performance over time. You can measure index performance over a set period by dividing the final index value by the beginning value.
How are indices maintained?
Index providers regularly review and rebalance indices to ensure they're still representative of the market they track and useful to investors. This might happen quarterly, twice a year or annually, for example, aiming to balance a need for fresh data with index stability and investment efficiency.
Securities may gain or lose index status or have their weighting adjusted because of a variety of factors. With stock market indices, for example, companies may go out of business, merge with others or be made private, meaning they're no longer eligible for listing. Alternatively, other eligible companies may simply overtake them based on comparative performance.
Some indices use buffers to limit how easily and frequently constituents change, however. An example is the ASX 200, which tracks the top 200 eligible companies listed on the Australian Securities Exchange. Its index provider, S&P Dow Jones Indices, uses the following buffers when adding or removing companies:
- Must be ranked 179th or higher for inclusion.
- Must be ranked 221st or lower for exclusion.
How index calculations can strengthen your trading
Understanding how indices are compiled and calculated can ultimately guide your trading analysis and help you make informed decisions.
Knowing which stocks have the largest weighting in popular stock market indices, for example, could improve your chances of success with index-linked trading products. If key stocks are trending in one direction, you might then reasonably judge that the overall index will follow.
Ready to broaden your index trading knowledge further? Head to our other market guides.