What is a Market Index? Types, Examples, and How It Works

A market index provides investors with a glimpse of the overall movement of a stock market. It enables investors to monitor and quantify the performance of market segments and facilitates comparative analysis. Market indices are used as benchmarks by funds and offer significant inputs in the management of passive funds.

Read on to understand the meaning and methodology of market indices, different types of market indices in India, usage in financial products, and their utility for investors.

• Table of contents

1. Market index meaning
2. The working of a market index
3. Market indices methodology
4. Market indices in India
5. Market indices based products
6. Market indices examples
7. Why are indices useful to investors?

Market index meaning

A market index is a statistical measure that captures the collective price movement of a group of securities. It monitors and quantifies the returns earned by particular market segments - such as sectors, industries, or the overall stock market. For instance, the NIFTY 50 monitors the 50 largest Indian firms traded on the National Stock Exchange.

Market indices enable investors to analyse the overall direction of financial markets. Indices provide benchmarks to gauge the performance of investment portfolios. The levels of indices provide information about overall market sentiment and economic trends. Investors use these indices to get a feel of the market and determine areas of opportunity.

Moreover, market indices assist in answering questions such as - Is the market overbought or underpriced? Which sectors are driving market momentum? How have broader markets performed relative to my investments? They facilitate comparative analysis against segment and market benchmarks.

Also Read: What are Index Funds?

Also Read: A beginner's guide to index funds: A passive approach to market-linked growth

The working of a market index

Market indices are constructed by index providers like MSCI, S&P, NSE, BSE using transparent, rules-based methodologies. The construction process involves the below.

• Defining eligibility criteria like market capitalisation, trading volume, financial viability for selecting constituents from a universe of securities. Criteria aim to filter liquid, investable stocks representing the market.
• Assigning weights to constituents based on market cap, equal weight, or other criteria to determine their influence on index performance. Market cap weighted indices reduce concentration risk.
• Periodically reviewing the portfolio by adding or deleting securities according to predefined rules. Reviews maintain continuity and investability as markets evolve.
• Tracking constituent prices throughout market hours to calculate real-time index values. Automated systems allow continuous tracking and fast computation.

Well-constructed indices objectively capture broad market performance and are resilient to constituent churn. Passive investors can reliably track index returns over long periods.

Market indices methodology

Market index methodologies aim to create investable, representative benchmarks. Key aspects include the below.

Universe definition- The index universe is chosen to represent a market segment - for instance BSE 200 companies or NIFTY sectoral indices. The universe sets the focus in terms of market coverage.

Selection & weighting- Constituents are selected from the universe and weighted as per transparent rules. Market cap weighted indices like NIFTY 50 assign higher weights to larger companies. Selection criteria determine index composition.

Maintenance- The portfolio undergoes periodic review to ensure continuity and investability. IPOs meeting criteria are added and failing companies are dropped. Maintaining investability enables index funds to closely track the index.

Index calculation- Real-time calculation uses prices of constituent stocks to update index values on a continuous basis. Automation ensures index values accurately reflect market movements.

Rebalancing- Scheduled rebalancing brings constituent weights back in line with the methodology rules. This minimises tracking error for index funds.

Transparency- Index rules and changes are publicly disseminated for clarity. Transparency ensures predictability in tracking for investors.

Market indices in India

There are various types of market indices catering to different segments. Below is an overview.

• Broad market indices like NIFTY 50, Sensex reflect overall market. They serve as key benchmarks for market-linked investments.
• Sectoral indices like NIFTY Pharma, Bankex track industry sectors. Used for evaluating sector performance.
• Thematic indices like NIFTY Dividend Opportunities focus on specific themes. Allow investors to take thematic bets.
• Capped indices like NIFTY 100 limit weight of larger stocks. Reduce concentration risk in portfolios.
• Equal weighted indices like NIFTY100 Equal Weight avoid skewness. Mitigate concentration risk.
• Total return indices like NIFTY 100 TR consider dividend reinvestment. Capture full returns.
• Growth indices like NIFTY Growth Sectors 15 reflect high growth companies. Identify high growth pockets.
• Custom indices tailored to specific methodologies, universes and themes. Provide specialised solutions.

Market indices based products

Market indices act as benchmarks for investment products like index funds and ETFs.

• Index mutual funds invest in securities constituting the index to match its performance. They offer a low cost way to gain index exposure.
• ETFs are exchange-traded funds that replicate index performance. Trade on exchange like stocks and can be bought/sold anytime.
• Derivatives like index futures and options use index levels to derive their value. Help hedge against market downturns.
• Structured products use index performance to calculate returns. Allow participation in index upside.
• Index-linked NFOs launch funds tracking specific indices. Expand choice for investors.

Usage of these products amplifies the reach and influence of indices like NIFTY 50 for investors.

Market indices examples

Here are some major market indices tracked by investors.

• NIFTY 50 - Flagship index of 50 large Indian stocks. Broadest benchmark of Indian equity markets.
• Sensex - Oldest index of 30 major BSE listed stocks. Most tracked index historically.
• NIFTY Next 50 - Measures performance of next 50 companies after NIFTY 50. Reflects mid cap segment.
• BSE 100 - Index of 100 large, liquid BSE stocks. Captures broader market.
• NIFTY Bank - Tracks major banking stocks. Benchmark for banking sector.
• NIFTY IT - Tracks major technology stocks. Benchmark for technology sector.
• NIFTY Dividend Opportunities 50 - Stocks with high dividend yields. Thematic index.
• NIFTY Midcap 150 - Midcap companies meeting eligibility criteria.

Why are indices useful to investors?

For investors, market indices serve various purposes. Below are some.

• Gauge overall market trends and sentiment. Assess investor euphoria or panic.
• Benchmark to assess active fund performance. Evaluate fund managers.
• Build passive portfolios tracking indices. Low cost index investing.
• Hedging market risk using index derivatives. Hedge portfolios against downturns.
• Develop index-linked investment strategies and products. Enhance product development.
• Analyse market segments by tracking focused indices. Compare segments.
• Construct thematic portfolios using specialised indices. Implement investment themes.
• Measure volatility and returns across indices. Gauge risk-return tradeoff.

Conclusion

Market indices are invaluable tools enabling investors to track and analyse financial markets. They capture market movements in a representative, transparent manner. Indices like NIFTY 50 serve as benchmarks for funds and derivatives. Investors utilise indices to gauge sentiment, evaluate fund performance, construct portfolios, and develop products.

FAQs

What do you mean by market index?

A market index is a numerical quantity that measures the performance of a basket of securities covering a segment of the market. It acts as a benchmark to measure total market movement and trends.

How to calculate market index?

Market indices are derived through transparent rules. Constituent prices are monitored in real-time to derive index values. Weighted average methodology assigns greater weights to large stocks. Index levels are continuously updated during market hours.

What are the different types of market indexes?

The main types of indices are broad market, sectoral, thematic, capped, equal weighted, total return, growth, and custom indices serving various methodologies.

How can investors use market indexes for investment decisions?

Investors use indices to measure market sentiment, compare fund performance against benchmark, build index-tracking portfolios, hedge market risk with derivatives, and create index-based strategies and financial products.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.