Sizing securities in an index
The most common way to weight securities is to look at the size of each index constituent. This is done differently across equities and fixed income.
In equities, weighting securities can mean looking at the market capitalization of a company.
Market capitalization refers to the size of a company in the stock market and is calculated by multiplying the number of shares by the share price. It does not reflect other possible measures of size such as the number of employees or sales volume. Market capitalization is important to many institutional investors as it helps them assess how can they access a firm’s capital and benefit from its growth over time.
To help investors better understand companies’ performance and risk, index providers, such as MSCI, may classify companies by size: large-, mid- and small-cap. Categorizing by size may attempt to avoid overlaps (a company cannot be big and small at the same time) and gaps (all companies are ‘assigned’ a size).
In fixed income, weighting can mean considering the debt outstanding for a specific issue. Index providers may also consider the coupon that may be payable, as that may have value for bond investors and be accounted for as part of their potential investment returns.
Updating indexes is a balancing act
Indexes change as companies and markets change. Companies may go out of business, they may merge with other companies and new companies may be listed. In the case of fixed income, some bonds reach maturity while new ones get issued.
Index providers impose regular and systematic reviews/rebalances on their indexes. Getting the balance right is important: frequent enough to prevent an index from retaining stale data, but not too frequent to require constant turnover by investors.
In equities, due to their more permanent nature (a company could exist in perpetuity), indexes may be rebalanced two to four times a year. Bond indexes are generally rebalanced more frequently, as the universes of available bonds changes more often than equities.
Calculating index value and returns
To calculate the value and returns, index providers may set out an index calculation methodology.
The method defines how the aggregate average value of all constituents is calculated at any point. This is usually called the index value and incorporates the total market capitalization of all the securities included in the index. At its most basic, an index value is based on stock prices, which form the basis of the returns (price return index).
Equity indexes may also be designed to account for other returns, such as dividends. This leads to the calculation of total return indexes. As most of us live in a world where taxes are due on any gains, index providers may also calculate net returns indexes, which incorporate taxes. This is a closer representation of what an institutional investor would experience in terms of returns after taxes.
Similarly, in fixed income, you can have price returns and total returns. For example, bonds may pay coupons to investors which would need to be accounted for in the index return calculation.
You need both deep knowledge and a systematic and well-defined methodology to construct efficient and relevant indexes. To remain useful for investors, indexes are updated and rebalanced to reflect changes in companies and markets. How often depends on the type of index.