How Indexes are created:
Ramifications for the Index Investor

By Rahul Seksaria, Assistant Editor

Not all indexes are created in the same way. How they are put together can affect investor returns. Three methods primarily used to construct indexes are:

• Market value-weighted Method - Each stock is given a weighting proportional to its market capitalization
• Price Weighted Method - Each stock is given a weighting proportional to its market price
• Equal Weighted Method - Each stock is equally weighted in the index

The market value-weighted method, where a company worth $2 Billion is given twice the weight of a company worth $1 Billion, is the most popular way of creating an index. The Standard & Poor's 500 Index is one example. A market value-weighted index allows investors to best capture total economic activity and changes in valuation of the companies in the index. By giving larger companies higher weighting, this method reflects the fact that large companies have larger revenues and profits and that any change will have a larger effect on economic activity than change in smaller companies. The NYSE Composite Index, Nasdaq Composite Index, Wilshire 5000, London FTSE, and MSCI Indexes are all constructed using the market value methodology.

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