What is an Index? Overview, Examples, Types, Investment Strategies and More

In this article, we will discuss

• What is an Index?
• How Stock Market Indices Work
• Methods to Calculate Indices
• Types of Market Indexes
• How to Invest in Market Indexes

If you follow the stock market news regularly, you may be familiar with headlines of the Nifty 50 rising or the Sensex shooting up by several points. However, beyond these headlines, not many investors pay attention to what a stock market index is and how it works. If you too are not aware of these crucial details, this article can help you become a more knowledgeable investor.

What is an Index?

A market index is a statistical tool that measures the performance of a segment of the financial market or the broad market as a whole. In simpler terms, it is a basket of stocks or other securities that are carefully chosen to represent a broader group of assets.

Once the assets or securities are chosen, their prices or values are used to compute the value of the index. Different methods of weighting such as those based on the price, market cap, revenue etc. can be used to compute the value of indices, which serve as benchmarks in index investing and index trading.

Stock market indexes are among the most common benchmarks used by investors and traders. Among these, you may already be familiar with Nifty 50 and Sensex. The Nifty 50 is the benchmark index of the National Stock Exchange (NSE) and consists of the top 50 companies listed on the exchange. Similarly, the Sensex is made up of the top 30 stocks on the Bombay Stock Exchange (BSE).

How Stock Market Indices Work

Stock market indexes work by aggregating the prices of selected stocks to provide a broad overview of the market's or market segment’s overall performance. They include a curated list of companies that represent specific sectors or the market as a whole.

The value of an index fluctuates based on the price changes of its constituent stocks. When these stocks rise in value, the index increases; when they fall, the index decreases. These market indexes are reviewed and updated periodically to ensure they accurately reflect the market. This involves adding or removing stocks based on specific criteria like market capitalisation or sector representation.

By tracking market indices, you can gauge market trends and make informed investment decisions about which stocks to hold and which ones to sell. Additionally, these indices serve as benchmarks for evaluating the performance of individual stocks or investment portfolios. In fact, many investment products like ETFs and mutual funds aim to replicate the performance of specific market indices.

Methods to Calculate Indices

A stock market index can be calculated in any of the following ways:

• Market Capitalisation-Weighted Index

In a market cap-weighted index, the value is calculated based on the total market capitalisation of the stocks that make up the index. Here, the effect of each stock on the value of the index is proportional to its market cap. This is because a float factor is allocated to each company in the index. This factor depends on the free float market capitalisation of the company. So, large-cap stocks in the index will have a higher influence on the value and movement of the index.

The Nifty 50 and the BSE Sensex are both capitalisation-weighted stock market indexes.

• Price-Weighted Index

A stock market index can also be calculated as a price-weighted statistical measure. In this case, the prices of the constituent stocks are used to compute the index value. So, stocks that are priced higher will exert more influence on the overall value of the stock market index than stocks that are priced lower. A divisor is used to adjust the prices of the stocks to arrive at the index value and an adjustment factor helps modify the index to account for dividend payouts and stock splits.

The Dow Jones Industrial Average (DJIA) is a price-weighted index.

• Equal-Weighted Index

As the name indicates, an equal-weighted stock market index is a statistical measure where each constituent company contributes equally to the index value. Unlike other methods that prioritise companies with larger market capitalisations or higher prices, this method prioritises each stock equally. This ensures that all the constituent companies influence the index value similarly, with no company or sector having any undue effect on the value of the stock market index.

Types of Market Indexes

Depending on the group of stocks that make up the index, you can find different types of stock market indices on the NSE and the BSE. Here is an overview of the various kinds of stock market indexes and other indices you can choose from.

• Broad Market Indices

Broad market indices consist of a group of stocks or securities that represent the market as a whole or a large section of the market. Both the Nifty 50 and the BSE Sensex are broad market indexes. This category also includes market cap-based indexes like the Nifty Midcap 150, Nifty LargeMidcap 250, BSE MidCap, BSE 400 MidSmallCap Index and other similar indices.

• Strategy-Based Indices

Strategy-based indices are designed to follow specific investment strategies like arbitrage, low volatility investing or high beta investing. These indices include stocks selected based on particular criteria or factors that align with the strategy, like high dividends or low price-to-earnings ratios. Some examples of strategy-based stock market indexes include Nifty 100 Equal Weight, Nifty500 Value 50, BSE Dividend Stability Index and BSE Momentum.

• Sectoral Indices

Sectoral indices focus on specific sectors of the economy like technology, healthcare or financial services. They include the top companies within a particular industry. So, they can offer valuable insights into the performance of a specific sector. Some common examples of sectoral stock market indexes include the BSE Commodities, BSE Energy, Nifty Auto and Nifty Bank, which track the commodities, energy, automobile and banking sectors respectively.

• Thematic Indices

Thematic indices include stocks selected based on broader themes or trends. Some examples of such themes include CPSEs, liquidity, non-cyclical investing or environmental, social, and governance (ESG) factors. These indices select companies that align with the chosen theme, thereby allowing investors to focus on emerging trends and long-term societal changes. Some examples of such indices include the Nifty100 ESG, Nifty100 ESG Leaders, BSE Private Banks Index and BSE CPSE.

• Fixed-Income Indices

Fixed-income indices track the performance of bonds and other debt instruments. They include securities like government bonds, corporate bonds and even municipal bonds. The values of these indices change as the bond values fluctuate to reflect interest rate movements and credit risk levels. These indices help you gauge the overall health of the fixed-income market and can be used as benchmarks for bond funds. Some examples include the Nifty Bharat Bond Index Series, Nifty 10-Year SDL Index and Nifty India Municipal Bond.

How to Invest in Market Indexes

Since indexes are only statistical measures, they are not instruments that exist or are traded on the exchange. So, you cannot directly invest or trade in an index. However, index investing and index trading are still possible via various other indirect channels, as explained below:

• Index Funds

Index funds are mutual funds that track a specific index. Their portfolios replicate the index to the maximum extent possible. However, these funds may also include a few other securities in their portfolios. You can choose from different index mutual funds in the market and curate your portfolio based on what you need to achieve financially.

• Exchange-Traded Funds (ETFs)

ETFs are designed much like mutual funds because they also include baskets of assets that replicate the composition of the benchmark index. However, unlike mutual funds, you can trade ETFs freely on the stock exchanges. This increases their liquidity. Furthermore, since ETFs are passive investments, they have lower expense ratios.

• Futures and Options Trading

You can also gain exposure to index trading via the F&O segment. More specifically, futures and options with various indexes as the underlying asset can help you leverage the changes in the value of those indexes and earn short-term gains in the process. You can hold simple positions in index futures or use multi-legged index options strategies to hedge your positions.

• Direct Equity Investing

If you are a seasoned investor, you can also design your own portfolio to replicate the benchmark index that you wish to track. However, this is a time-consuming process as you need to review your portfolio regularly and ensure that it is rebalanced to track the index accurately.

Whichever method of index trading or index investing you choose, you need a demat and trading account to gain exposure to indexes in the market. A reliable brokerage partner like Samco Securities can help you here. Open a demat account and a trading account with Samco Securities today and get started on your index trading or index investing journey.

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