THE objective of creating an index is to reflect the happenings in a particular universe of stocks with a small sample from that universe.
These short-listed stocks reflect the picture of that particular universe not just at the time of short-listing but also on a day-to-day basis.
So, if the price movement of the 30 companies of Sensex, or the 50 companies of S&P CNX Nifty, are making the index rise by say 1.5 per cent on a given day, non-Sensex and non-Nifty stocks should not be moving downwards.
In the modern financial world, an index should also be easily tradable. Mutual funds' index fund schemes or exchange-traded funds (ETFs) should be able to buy and sell the underlying stocks instantaneously and at the least transaction cost.
The criteria, therefore, to include stocks in an index are market capitalisation, liquidity and the sector they belong to.
Sensex and Nifty have stocks from across sectors and that is why they are referred to as benchmark indices. For example, financial sector stocks make up for 23 per cent in Sensex, followed by oil & gas, information technology, capital goods, fast moving consumer goods sectors, which have 18 per cent, 14 per cent, 10 per cent and 8 per cent weightages, respectively.
There are indices which track a group of companies from a particular sector.
These are known as sectoral indices.
One such example is the BSE information technology index. The index includes stocks such as Infosys, Tata Consultancy Services and Wipro, which are from the same sector.
The significance of liquidity can never be understated. For including stocks in its Nifty index, NSE uses a measure of liquidity called `impact cost' that defines as "the cost of executing a transaction in a given stock for a specific predefined order size", in comparison with the bidask spread at any given point in time.
Lastly, a good index should be reviewed by the respective stock exchanges at frequent intervals, say every quarter, in order to weed out stocks where liquidity or market cap would have fallen severely.
In other words, an index has to be dynamic and not stale.
