Constituents are stocks that form part of major market indices, such as Nifty 50 and Sensex in India. It refers to a member stock or a component stock of a market index. The total number of stocks of all member companies is used for estimating the net value of a market index. Every constituent stock of an index has to meet some criteria as far as market capitalization is concerned, apart from the market exposure and liquidity before being selected as part of a market index.
What is the significance of constituents?
Market indices are used to keep a track of the performance of stocks that are being traded in a particular market. These also help in estimating sector development.
A company’s stock that is a constituent of a particular index enjoys the advantage of enhanced exposure and higher credibility. This can also be a booster for the share price. Once a company’s stock becomes a constituent of a market index, the company has to mandatorily follow certain guidelines to remain part of the index composition.
Eligibility criteria for constituent stock selection at NSE
Here are some of the eligibility criteria set by NSE for constituent stock selection:
- For a stock to be possibly included in the NIFTY50 and for the basket size of Rs. 100 million, it has to be traded at an average impact cost of 0.50% or lower in the past six months as per 90% of the observations. Market impact cost is one of the best measures of a stock’s liquidity, as it accurately reflects the cost of executing a transaction in a given stock on the index.
- The company must possess a listing history of at least 6 months.
- Only those companies allowed to trade in F&O segment are eligible to be included as constituents of the index.
- A company declaring an IPO is eligible for inclusion in the index provided it fulfils the normal eligibility criteria of the index for a 3-month period as against 6-month period.
Eligibility criteria for constituent stock selection at BSE Sensex
Here are some of the eligibility criteria for BSE constituent stock selection:
- The company must possess a listing history of at least 3 months.
- Stock selection aims at maintaining the index sector weights which are broadly in-line with the overall market. The stocks are weighted in the index as per their float -adjusted market capitalization.
- The constituent stock should have been traded at BSE on every trading day during a three month listing/reference period.
- Eligible companies should have reported revenue from core activities in the past four quarters.
- Index constituents must meet the total market capitalization, cumulative value traded, float market capitalization, and minimum weight criteria set by the exchange.
Stock exchanges in India
A stock exchange is a government-authorised entity through which traders and investors can trade any listed company’s securities. It facilitates the trading of stocks, bonds and ETPs (exchange-traded products).
The BSE Sensex, known as a benchmark index, is one of the major indexes in India. It comprises 30 of the largest stocks listed on the Bombay Stock Exchange, which is the country’s oldest stock exchange.
NSE Nifty 50 is another popular benchmark index in the country. It comprises 50 of the largest stocks traded on the National Stock Exchange, the country’s largest stock exchange.
Why are indices needed?
The primary reason for having indices is to make trading easy for investors. Also a stock index serves as the barometer of the performance of the stock market and also the economy in general. A stock market without any categorisation via indices will be an open marketplace where all the stocks on the exchange are available for buying or selling. In such a scenario, an investor wouldn’t know which stock carries a higher m-cap or which stocks have lower value or stocks that are ‘better than other stocks. To offer clarity to stock market functionality, the stock market indices prove to be important. These make it easier for traders and investors to trade stocks, as there is more visibility on constituent stocks.
Selection of stocks in indices
Indices are means of grouping together the best stocks that have a significant impact on the economy and are the best reflection of markets in general. So, how does a stock market index in India select its stocks?
When an index, like Sensex or Nifty, moves up or down, it means that the stocks constituting these indices are performing better or worse. This, however, does not mean that if one company listed on an index goes up by a certain percentage, the index will correspondingly go up by the same level. The reason is that there are other stocks included in the index which could have gone up or down and thereby influenced the index movement.
Different stocks have different weights assigned within an index. This depends on the stock selection strategy adopted by the index. There are two primary factors influencing stock selection:
Companies that have the largest market capitalisation (m-cap) are selected and grouped together in an index when the stock selection strategy is based on market capitalisation. M-cap is the net value of a company measured in terms of outstanding shares issued. Companies with the largest M-cap have a bigger weight age in an index’s value, whereas stocks with small m-cap do not influence the index movement significantly. Indian indices commonly use free-float market capitalization to assign weights to stocks. Free float m-cap generally excludes promoter-held shares.
Some indices across the globe also use price to assign weight age to stocks within an index. Japan’s Nikkei 225 is an example of an index using price for assigning weight age. Here, companies that have a higher stock price enjoy a higher weight age and tend to impact the index more than the stocks with lower values.
Before investing in stocks, investors and traders must consider the constituent stocks of an index to get clarity on the index composition. It can help them in better selection of stocks as per their investment goals.
Index rebalancing means modifying an index composition to keep it balanced and diversified. The objective is to attain the same composition level as at conception and according to its stated methodology.
A stock market index is calculated by adding the stock prices of the selected companies and dividing it by the divisor, which can change in case of stock splits, dividends, or when a company is added or taken off the index.
Market capitalization is the net value of a company’s total number of outstanding shares. It’s estimated by multiplying the company’s stock price with the total number of outstanding shares. Market capitalization can be used to assess the value of a company’s stock before buying
Market cap may not directly affect a company’s share price. This is because market cap is the company’s total outstanding shares multiplied by its share price. Since it reflects the perceived value of a company in the eyes of investors, it may impact share prices in the long run
Passive mutual funds mimic the stock composition of the chosen index and invest in stocks that are part of the index in the same proportion as those in the index.