What is an index, and how does it work?
Indices are designed to measure the performance of a basket of assets. In this article, we use equity/stock indices as an example.
Still, it is important to note that their application is asset class-wide and not only limited to stocks. Beyond performance measurement, indices play an important role in the world of financial markets. Many fund managers offer unit trusts and ETFs that track indices.
These managers are known as ‘passive’ managers. Active fund managers manage funds with the objective of outperforming their adopted benchmark, and the benchmark is usually an index. If we delve deeper and consider the world of derivatives, it gets a bit more complicated.
In a nutshell, you can buy a derivative, such as a futures contract, that tracks the performance of an index like the Top 40. You don’t physically own each stock in the index. The contract you buy will mirror the index’s performance very closely.
There are more nuances to indices and index construction than one would think.
A couple of FAQs related to indexing generally go along the lines of:
- How is the weight of a stock in the basket determined, and what is a free float factor?
- How are corporate actions dealt with? For example, for an equity index that measures the performance of a basket of stocks assuming dividends are reinvested, when are the dividends reinvested?
- Are gross, or net of-tax dividends assumed to be invested? This is known as a total return index.
- Can stocks go into an index and fall out?
- Do index providers like the FTSE/JSE have a rule book that they follow when maintaining their indices?
The above questions are important to consider when developing your understanding of how indices work and ultimately understanding what an index is.
Let’s look at the answers to these questions below:
How are stock weights determined?
The weight of a stock in a market index is generally determined according to its net market cap. The net market cap is calculated by adjusting the total market cap by the proportion of shares available to trade. This is known as the free float factor.
The total market cap is the market value of the stock. It can be calculated by multiplying the stock price by the shares in issue. Many companies have low free float factors. For example, take a stock with a free float factor of 10%; this means that 10% of its shares are available to trade. The rest could be held by a large strategic investor or the founders who have no intention of selling them in the short to medium term.
Imagine the stock was weighted by its total market cap. Passive funds tracking the index would have a tough time buying these shares as there would be very little available to trade in the open market.
Corporate actions – how are dividends treated?
The FTSE/JSE total return indices assume that dividends are reinvested on the ex-dividend date. The ex-dividend date is when new investors/buyers will not be entitled to the dividend being paid.
In practice, a passive fund manager can’t always reinvest the dividend on the ex-date as the physical cash inflow sometimes occurs after t + 3, which is the settlement date. This will create a small degree of divergence from the return of the benchmark, known as a tracking error.
There are two types of total return indices: gross and net. Gross total return indices assume that the full dividend is reinvested and no dividend withholding tax (DWT) is paid.
On the other hand, net total return indices assume that the dividend after DWT is reinvested. The reason why there are two versions is that some investors are exempt from DWT.
For example, locally, unit trusts managed by institutional investors* are exempt from DWT, whereas retail investors pay the full 20%. *Tax will be incurred by the investor in the unit trust depending on their tax circumstances.
Index reviews and stock changes
Depending on performance and corporate actions, stocks do get added and removed from indices. This is usually done at each review.
The FTSE/JSE indices get reviewed every quarter in March, June, September and December. Any free float or shares in issue data changes are also considered in this review.
Using the Top 40 index as an example, the JSE ranks constituents/members and non-constituents/non-members on the ranking cut date. This falls about a month before the rebalance date when changes become effective.
If there are non-constituents that rank at or above the buffer of 35, the stock will be added, and the lowest-ranking constituent will be removed.
Conversely, suppose a constituent falls to rank 46 or below. In that case, it will be removed, and the highest-ranking non-constituent will be added.
Rules-based or on the fly?
All the major index providers have a publicly available methodology and rule book. This is designed to create transparency around their index construction process.
The approach adopted by each can differ quite notably. For example, the MSCI is not as transparent with their ranking cut date as the FTSE/JSE and the S&P.
We hope this answers your question about what an index is and how it works.