Lesson 2 of 7 · 12 min
Building an index: target market, constituents and weighting
Building an index is like building a portfolio: choose the market to represent, pick the securities, decide how much of each to hold, and then decide when to rebalance and when to review the list.
In short
- Index providers make five decisions: target market, security selection, weighting, rebalancing frequency and when to re-examine selection and weighting.
- The target market comes first and can be broad or narrow (asset class, region, exchange, sector, size, style, duration, credit quality). It defines the investment universe.
- Constituents can be nearly the whole target market or a representative sample; the number can be fixed or allowed to vary.
- Most indexes select constituents with objective rules; some use a selection committee with more subjective judgement.
- The four weighting families are price, equal, market-capitalization (usually float-adjusted) and fundamental. The choice changes the index's value and returns.
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