How an index is built

Two indices can contain exactly the same companies, and still show different results. It all comes down to the weights.

The most common rule is called market-cap weighting. Each company weighs according to its stock market value.

Say three companies. A is worth six hundred billion, B three hundred, C one hundred. In the index, A weighs sixty per cent.

If A rises ten per cent and the others do not move, the index rises six per cent. From A alone.

And the more a company rises, the more it weighs. If A gains fifty per cent, its weight goes above sixty-nine per cent.

It is mechanical: winners grow bigger in the index. Nobody decided it, the rule does it.

The advantage: the index follows the market as it is, without buying or selling anything when prices move.

Second rule, more discreet: the free float. Only shares that can really be traded are counted.

For the example: a company is worth one hundred billion, but its founder keeps half the shares, and never sells them.

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Those shares do not circulate. The index only counts the other half: fifty billion.

Same for stakes held by a state or by another company. What cannot be bought does not count.

Third approach: equal weighting. You put the same amount on each line, whatever its size.

Back to A, B and C. A third each. If A rises ten per cent, the index rises three point three per cent.

Small companies weigh as much as giants. The result looks nothing like the first index.

But this balance does not hold by itself. Say one thousand euros on each line. A doubles: it is now half the basket.

To get back to a third each, you have to sell a little over six hundred and sixty-six euros of A, and buy B and C.

That is rebalancing. The index sells what has risen, buys back what has fallen, on fixed dates.

And every index rewrites itself like this, several times a year. Float is adjusted, members change, weights are recalculated.

It happens quietly, one evening at the close. The next day, the number has the same name, but not quite the same contents.

Funds that copy the index must then buy and sell at the same moment. On those days, volumes soar.

Market cap: the market as it is, with its giants. Equal weight: every company counts the same, but you must rebalance constantly.

No rule is neutral. Before comparing two indices, first ask how each one weights its members.