How Stocks are Included in an Index?

Every day we come across the news stating that Sensex rose by 200 points, or Nifty fell by 100 points. All such news denotes just one thing- the performance of the market. If Sensex or Nifty rises, the market has performed better than yesterday; or if it falls, it has performed poorer than yesterday.

However, the question still pertains. Does this fall or rise stand explain absolute relation with stocks? If Sensex falls by 500 points, does it mean all stocks fall that day? If yes, then by how much? Similarly, if the Nifty rises by 100 points, will all stocks increase by a certain price? This piece talks about the stocks and their relation with their index.

The Index

First, it is important to understand what an index is. The index is a benchmark against which one may compare anything. If I tell you that the Index went up, it is not a complete sentence. It will be complete if I mention that the index improved when compared to the index value on a certain date. Hence, it would be better to say that the market performed better when compared to yesterday, the previous quarter, or last financial year. This is how it acts as a yardstick for comparison.

Secondly, the index is not an absolute measure. If the market jumped up by 100 points, it does not mean that all stocks jumped up by a certain value. Some stocks would fare well while some would do poorly. In general, it only indicates that more companies did well than those that perform poorly. It still does not indicate which specific companies performed well and by how much.

What is the use of an Index?

If an index does not depict anything specific, and even less quantifiable, why is it important for markets?

The utility of indexes is easy to understand. If I ask you how much time it would take me to drive from point A to point B in your city, how will you get the values? There are so many nooks and corners, narrow streets, highways and main roads. How can you give me an exact time? Truth is that no one can.

Nevertheless, you can still give me an indication of time. You can try knowing the time taken in the important roads, and bottlenecks. Based on that you may tell me the time I might take to reach from A to B. That is how we usually tell people!

Similarly, stock indices are not exact. Stock exchanges like BSE have more than 2500 companies. An index cannot compute all the companies big and small so they have a handful of companies. One must know that SENSEX, the index of the Bombay Stock Exchange, is based on only 30 companies! So any rise or fall in any Sensex is based on rise or fall in these 30 companies only.

However, the index is designed so that it covers all broad sectors of the economy. Hence, any change in the index is indicative of the performance of all the companies in general. Therefore, any change in one or more sectors is represented by a change in the index values; though all companies of the sector are not included in the index.    

However, one must be cautious that a rise in Sensex might mean that 30 companies, in general, are doing good, but it would not be an absolute representation of how the rest 2500 companies have been doing. If you see Sensex rising to all-time highs in the current slowdown, you will be able to see this deception. Big companies are undoubtedly growing, but it does not represent the plight of investors of smaller companies. This is where indices hide more than they show.

Yet, if there is so much more than meets the eye, why are indices still popular? Answers lie in the way they pick these representative companies.

Including Companies in Index

Indices have several criteria for including any company. Each index has a different number of companies and different criteria to include a company in its index. Please note that our discussion will be around important indices like Sensex, Nifty or NASDAQ, unlike their sub-indices like Bank Nifty or Auto Nifty.

Inclusion Criteria

Each index has its number. While Sensex considers 30 companies for calibrating its index, Nifty uses 50. Secondly, each index ensures that it includes companies from all the sectors of the economy. This ensures that the index is right representative of all the companies in the exchange. Hence, it is a rare chance that all 30 companies of Sensex would perform differently from other 2500 companies. 

Some companies comprising 30 stocks of BSE Sensex are:

The third criteria mandate companies to have a business based in India. Nestle is from Switzerland but it functions in India as well. So it is eligible to be on the list. A fourth criterion is that the stock should be available to be traded in the derivatives segment, like Options and Futures. These jargons might be new for beginners but unfortunately, they are beyond the scope of this article.

The Technical Criteria

There are indices like Nifty, and then there are sub-indices like Bank Nifty or Auto Nifty. These are sector-specific indices. The following criteria are common for inclusion in indices as well as sub-indices.

The first criterion is the market capitalization based weighted system. Market capitalization (or market cap) means the total value of all the shares of the company. Mathematically it is the number of shares issued by the company multiplied by the price of its share. 

However, here our discussion is limited to ‘free-float shares’. Free-floating shares are those shares that are available to trade on an exchange. For example, a company AJ issues 100 shares. Out of which its promoters hold 80, which they will not trade. Rest 20 was opened to the public through IPO for trading on the exchange. Only these 20 shares being traded on the exchange are called free-floating shares. Indices consider the market cap of only free-floating shares. The weighted system is based on this free-float market cap. Say market cap of all shares of company AJ is ₹1 Lakh. Meanwhile, the market cap of all companies of the exchange is ₹10 Lakhs. Hence, the weight of AJ is 10% in the index. Some indices consider share prices as a weight assigning criteria, like Japan’s Nikkei 225.

The second criterion is liquidity. Stock must be traded frequently and easily on the exchange. This is decided based on the ‘average impact cost’. The average impact cost should be less than 0.5% in 90% of trading sessions in the past six months. Here is a broad idea of ‘Average Impact Cost’.

Suppose you want to buy 100 shares of AJ Company for ₹50, and you are the highest bidder. The seller quotes a price of ₹60. He is selling for the cheapest. Now the ideal price is assumed to be an average of this, ₹55. Now say two sellers are selling 50 shares each, one at ₹60; and other at the next best price of ₹62. Therefore, the average price you can buy is ₹61. The average impact cost will be 100*(₹61 – ₹55 )/₹61 = 9.83%

The Exclusion

In recent news, Yes Bank was removed from Sensex and replaced by Nestle India. This happened because each index reviews its companies every 6 months. If they fail to be part of the criteria, the next best companies are included to ensure better representation of market sentiment. Besides, it is well-curated so that the index needs not to be recalibrated and see a sudden rise or fall.

Yes Bank failed to maintain its market cap and its constant sell-off led to increased impact cost. Hence, it was replaced along with some others in the semi-annual review.

Winding Down

The purpose of the article has been to highlight the importance of an index; and why it is not all-important. Each stock exchange has a company that decides to keep or remove a company in the index. They have their criteria. When people say that Sensex is falling, it is indicative that most companies across sectors are not doing well. Hence, it causes worry to investors. However, it is different from keeping track of individual stocks and the way they rise or fall against the index. The relation between stock and index is just like symptoms of Coronavirus. If one has a fever, it is a symptom. However, she may or may not be infected with Coronavirus. Only certain tests could tell.     

Hope you like this information and for more information on stocks or index visit our stock analysis tool Ticker.