NISM Series XIX-E · Chapter 8: Indices and Benchmarking

L1 · Foundation

What an Index Is and How It Is Built

What a market index measures and why it exists, its four uses, the two things that make indices differ, the four weighting methods, free float, how Sensex and NIFTY 50 pick their stocks, and the families of equity indices from broad-market to style, sectoral, total return, dollar-denominated, global and MSCI.

14 min read · Worth 4% of the paper · Written from pages 198–226 of the official NISM workbook · Updated 17 September 2026

What an Index Is and How It Is Built

8.1 What an index is

The price of most shares moves with the market. So investors want a single measure of how the whole market did. That measure is an index.

The dictionary meaning of index is "a system of numbers used for comparing values of things that change according to each other or a fixed standard". A market index does exactly this. It shows the change in value of its underlying over a period of time, and from a base value used as the reference.

8.2 Uses of indices

Charles H. Dow and Edward D. Jones introduced the Dow Jones Average in 1884. It was the world's first security market index, and its only aim was to give a simple indicator of the market. Today indices have four uses:

A gauge of the market — the original purpose. An index reflects the collective opinion of market participants.
Benchmarking investments and actively managed portfolios — did the manager beat the index?
The model portfolio for index funds — the basis of passive investing.
A proxy for the market portfolio in the CAPM, when calculating systematic risk. The true market portfolio holds all risky assets, so a broad-based index stands in for it.

8.3 What makes indices differ

There are over two million indices globally. A footnote cites the Index Industry Association: 2.96 million indexes in 2019. They differ in two ways:

Sample size. Computers can now include every stock, but many popular indices are still sample based. For Indian large caps, BSE Sensex has 30 stocks and NIFTY 50 has 50. The sample must be representative of the population.
Weighting scheme. There are four ways to weight constituents:

Method	Weight based on	Example
Price-weighted	Share price	Dow Jones Industrial Average
Value-weighted (market-cap)	Market capitalisation or free-float market cap	Sensex, NIFTY 50
Equal-weighted	Same weight for every stock	—
Fundamental-weighted	Sales, earnings, book value, dividends etc.	"Alternative indices"

8.3.1 Price-weighted index

Add up the prices of the constituents and divide by a divisor.

The index divisor (Box 8.1) is a number chosen at inception so the index starts at a convenient value such as 100 or 1,000. BSE Sensex has an initial value of 100. The index provider adjusts the divisor so that the index does not jump for reasons unrelated to price changes — such as a stock split or a change of constituents.

Merit: very easy to calculate — a simple average of prices. That mattered before computers.

Two pitfalls:

A high-priced stock carries more weight. A 5 percent change in a ₹5,000 stock moves the index more than a 50 percent change in a ₹50 stock.
Downward bias. Fast-growing companies have high prices and tend to split. After each split, they lose weight in the index.

8.3.2 Value-weighted index

Each stock's weight = its market cap ÷ total market cap of all constituents. Market cap = shares outstanding (or free-float shares) × current price.

A given percentage change in a large company moves the index more than the same change in a small one.
There is an automatic adjustment for stock splits and other capital changes.
This makes it the ideal choice for index funds and index derivatives.

Sensex moved to free-float on September 1, 2003. NIFTY 50 moved to free-float on June 26, 2009.

Free float (Box 8.2)

Free float measures the shares actually available for public investment. It separates strategic (control) shareholders from holders who buy and sell on price and prospects. These are generally excluded:

Shares of founders, directors or acquirers with a control element
Holders with "Controlling Interest"
Government holdings as promoter or acquirer
Holdings through the FDI route
Strategic stakes by private companies or individuals
Cross-holdings by associate or group companies
Equity held by Employee Welfare Trusts
Locked-in shares and shares not normally sold in the open market

8.3.3 Equal-weighted index

Every stock carries the same weight, whatever its price or size. A ₹2,500 stock matters as much as a ₹40 stock. It is like investing the same rupee amount in each stock. The index moves by the arithmetic mean of the percentage changes, though some equal-weighted indices use a geometric average.

Merit: no price or value bias.
Drawback: index funds built on it must rebalance often. When a stock falls they buy more; when it rises they sell. This means high portfolio turnover and higher transaction cost.

8.3.4 Fundamental-weighted and factor-based index

A criticism of value weighting: it overweights overvalued stocks and underweights undervalued ones. So indexers began weighting by fundamentals — book value, cash flows, dividends, sales, profits, net assets. These are also called alternative indices. One factor or several may be used; with several, each factor's weight must be decided.

The workbook adds that some return factors are specific to a security and some are common to a group. The risk premium is the reward for exposure to these systematic risk factors.

8.4 How Sensex and NIFTY 50 pick stocks

Index providers make two big decisions — how many constituents and how to weight them — and then follow a methodology.

S&P BSE Sensex (methodology of January 2021)

Universe: constituents of the S&P BSE 100. The number of companies is fixed at 30, though DVRs can make the stock count exceed 30.
Listing history of at least six months at BSE.
Traded on every trading day during the six-month reference period.
DVRs are aggregated with the company's common stock.

Construction steps:

Rank by average six-month float-adjusted market cap — pick the top 75.
Rank by average six-month total market cap — pick the top 75.
Combine and sort by annualised traded value. Exclude companies with a cumulative annualised traded value greater than 98%.
Sort by float-adjusted market cap. Exclude weights below 0.5%.
Select: the top 21 go in regardless of sector. Existing constituents ranked 22–39 fill up to 30. If still short, non-constituents ranked 22–30 are picked, preferring under-represented sectors versus the S&P BSE All Cap. If still short, pick by rank.

Annualised traded value uses the median of monthly medians of daily traded values, annualised on 250 trading days. All additions and deletions are at the discretion of the index committee. Constituents are weighted by float-adjusted market cap.

NIFTY 50

Trading frequency of 100% in the last six months.
Average impact cost of 0.50% or less during the last six months, for 90% of the observations, for a portfolio of ₹10 crore.
Average free-float market cap at least 1.5 times that of the smallest constituent.

Impact cost is the percentage mark-up paid when buying or selling a quantity, compared with the ideal price of (best buy + best sell) ÷ 2.

Index values are disseminated up to two decimal places.

8.5 The families of stock market indices

Family	What it tracks	Examples from the workbook
Broad-based	An entire market segment	NIFTY 500 — about 96.1% of NSE free-float market cap as on March 29, 2019. Russell 3000 — about 98% of the US equity market
Market-cap based	Large, mid or small caps	NIFTY 50, Next 50, 100, 200, 500, Midcap 150
Style	Value or growth stocks	—
Cap-and-style	Six blends: large/mid/small × value/growth	—
Sectoral	One sector	Nifty Auto, Nifty Bank, Nifty Consumer Durables, Nifty Financial Services, S&P BSE Energy, S&P BSE Auto, S&P BSE Realty
Total Return	Price plus dividends	—
Dollar-denominated	Returns in USD	NIFTY50 USD
Global	Many countries	S&P Global BMI, MSCI World, FTSE Global Equity

Box 8.3 — market-cap indices

Index	What it holds
NIFTY 50	50 well-diversified companies, free-float method
NIFTY Next 50	50 companies from NIFTY 100 after excluding the NIFTY 50
NIFTY 100	NIFTY 50 + NIFTY Next 50 combined
NIFTY 200	All of NIFTY 100 and NIFTY Midcap 100 — large and mid caps
NIFTY 500	Top 500 companies on full market cap from the eligible universe
NIFTY Midcap 150	The next 150 companies — ranked 101 to 250 — on full market cap from NIFTY 500

When market caps change, stocks migrate between categories.

Style indices

	Value stocks	Growth stocks
P/E and P/B	Low	High
Dividend yield	High	Low
Focus in P/E = Price ÷ EPS	The numerator (price) — "cheap"	The denominator (earnings) — rapid EPS growth
Implicit assumption	P/E is below normal and the market will correct it	P/E stays roughly constant, so price rises with earnings
The story	Share price, expecting a correction	The company's economic "story", less regard to valuation

Style indices have much higher turnover than broad indices, because valuation ratios change and stocks migrate between style categories at reconstitution.

Total Return Index

A price index ignores dividends. A Total Return Index reflects (a) price movements and (b) dividend receipts. Dividends are indexed on the ex-date and reinvested in the index. The price index and TR index share the same base.

NIFTY50 USD

NIFTY50 USD is NIFTY 50 measured in dollars, for foreign investors:

NIFTY50 USD = Closing NIFTY 50 × Exchange rate on base date ÷ Exchange rate for the day

Its base date is the same as NIFTY 50 — November 3, 1995 — with a base value of 1,000. NIFTY 50 is also computed in Australian and Canadian dollars.

Global equity indices (Box 8.4)

Many global indices cover over 90% of each market's investable market cap.

Index	Facts
S&P Global Broad Market Index	Since 1989; about 10,000 stocks from 25 developed and 25 emerging markets
MSCI World	Large and mid caps across 23 developed markets; 1,601 constituents; about 85% of free-float market cap in each country
FTSE Global Equity Index series	Over 16,000 large, mid, small and micro-cap securities across 49 markets

GDP-weighted against market-cap-weighted

Market-cap indices ignore unlisted companies, including big state-owned ones. They also tilt towards developed countries, which have higher market-cap-to-GDP ratios, so emerging and frontier markets are under-represented. The fix is to weight countries by GDP. The MSCI World GDP Weighted Index, based on MSCI World (23 developed markets), was launched on September 30, 1988.

MSCI India

Country indices built by different providers cannot be compared, because methods differ. MSCI gives consistent treatment across all markets.

Covers large and mid caps; 86 constituents; about 85% of Indian equity market cap.
Stresses liquidity (measured by impact cost), investability and replicability.
Reviewed quarterly — February, May, August and November. In the May and November semi-annual reviews it is rebalanced and cap cut-offs are recalculated.
Global investors may prefer it for benchmarking.

Think of it like this

An index is the thermometer for the market's fever

A doctor does not examine every cell of a patient to know whether he has fever — a thermometer reading gives a quick overall picture. An index does the same for a market of thousands of shares. It is the "gauge of the market", the original purpose of the Dow Jones Average in 1884. And just as two thermometers can give slightly different readings, Sensex (30 stocks) and NIFTY 50 (50 stocks) can differ because of sample size and weighting.

The divisor is the tailor letting out a kurta after Diwali

A tailor measures a boy and stitches a kurta. When the boy's shape changes for a reason other than growing — say he now wears a thick sweater underneath — the tailor adjusts the pattern so the fit stays the same. The index divisor works the same way. When a stock splits or a constituent is replaced, nothing about the market has really changed, so the provider adjusts the divisor to keep the index level unchanged. In the workbook, a 2-for-1 split moves the divisor from 3.7 to 3.2 and the index stays at 10.

Price weighting is judging a cricket team by its tallest players

Imagine picking a team's "average strength" by adding up everyone's height. The tallest players dominate the number, even if a short opener scores the most runs. A price-weighted index does this with share prices: a 5 percent move in a ₹5,000 stock outweighs a 50 percent move in a ₹50 stock. And when a tall player "splits" — the share price halves after a split — he suddenly counts for less, which is the downward bias against growing companies.

Equal weighting is the kitty party where everyone puts in the same amount

At a kitty party each member contributes the same ₹2,000, whether she is the richest in the colony or not. An equal-weighted index treats every stock the same way — it is equivalent to investing the same rupee amount in each. But to keep contributions equal as fortunes change, the kitty must keep rebalancing: take a little from those who have gained, top up those who have lost. For an index fund, that constant buying and selling means high turnover and higher transaction cost.

Free float is the flats actually up for rent in a housing society

A society has 200 flats, but the builder keeps 40, the founding families live in 60, and 20 are locked in a legal dispute. Only 80 are truly available to tenants. A free-float index counts only those "available" shares — it excludes promoter and controlling holdings, government promoter stakes, FDI-route holdings, cross-holdings, employee welfare trusts and locked-in shares. That gives a truer picture of what investors can actually buy.

Key terms in this chapter

Absolute-return benchmark: A fixed rate, such as 10 percent a year, set by the manager at launch for funds that aim to make returns independent of market movements, instead of a market index.
Alpha: The excess return of an AIF over its benchmark for the same period. Using the CAPM, alpha = actual return − expected return, where expected return = Rf + β × (Rm − Rf).
Benchmark: A comparable fund or index with similar risk-return characteristics to the AIF being monitored. Under GIPS it should be specified in advance, relevant, measurable, unambiguous, representative, accountable, investable and complete.
Benchmarking Agency: An agency notified by an association representing at least 33 percent of AIFs, which collects data from AIFs that have completed one year from First Close and publishes industry benchmarks half-yearly, in INR and USD.
Broad-based index: An index representing an entire market segment and a large share of the selected market.
Equal-weighted index: An index where every constituent has the same weight regardless of price or size, moving by the average of percentage changes. It has no price or value bias, but index funds built on it face high turnover.
Free float: The shares actually available for public investment, excluding promoter and controlling holdings, government promoter stakes, FDI-route holdings, strategic stakes, cross-holdings, employee welfare trust holdings and locked-in shares.
Fundamental-weighted index: Also called an alternative index. Weights constituents by fundamentals such as sales, earnings, book value, cash flows or dividends, to counter value weighting's overweighting of overvalued stocks.
GDP-weighted index: A global index that weights countries by economic size rather than stock market size, correcting the tilt of market-cap indices towards developed countries.
Impact cost: The percentage mark-up suffered when buying or selling a desired quantity of a security compared with its ideal price, (best buy + best sell) ÷ 2. NIFTY 50 requires 0.50% or less for 90% of observations on a ₹10 crore portfolio.
Index: A composite measure reflecting the change in value of a group of securities over time and from a base value. The dictionary meaning is "a system of numbers used for comparing values of things that change according to each other or a fixed standard".
Index divisor: A number chosen at inception so the index starts at a convenient value such as 100 or 1,000, and adjusted afterwards so that events unrelated to price — splits, constituent changes — do not change the index level.
MSCI India Index: An index of large and mid-cap Indian stocks with 86 constituents covering about 85% of Indian equity market cap, reviewed quarterly and rebalanced in May and November.
NIFTY50 USD: NIFTY 50 measured in US dollars: closing NIFTY 50 × exchange rate on base date ÷ exchange rate for the day. Base date November 3, 1995, base value 1,000.
NIFTY G-Sec Indices: Indices of Government of India bonds across 6 Macaulay duration buckets, each holding up to 3 liquid bonds with over ₹5,000 crore outstanding, weighted by amount outstanding and rebalanced monthly.
NIFTY Hybrid Index series: Six indices blending NIFTY 50 TR with fixed income aggregate indices in set proportions, such as 70:30 or 50:50, with weights reset monthly.
Performance Report: A customised, possibly fee-based report a Benchmarking Agency prepares at an AIF's request with the express consent of the AIFs whose data is used — distinct from the standard Benchmark Report under the SEBI mandate.
Price-weighted index: An index computed by summing constituent prices and dividing by a divisor, so higher-priced stocks carry more weight. Easy to calculate, but biased against stocks that split.
Sectoral index: An index tracking one sector such as IT, banking, FMCG or pharma, used to benchmark sectoral portfolios.
Style index: An index of value or growth stocks. Value stocks have low P/E and P/B and high dividend yield; growth stocks the opposite. Style indices have much higher turnover than broad indices.
Total return bond index: A bond index replicating the return from holding the index portfolio, including price movements, accrued interest and cash flows such as coupons, redemptions and repurchases.
Total Return Index: An index reflecting both constituent price movements and dividends received, with dividends indexed on the ex-date and reinvested. Investors in index stocks should benchmark against it rather than the price index.
Value-weighted index: An index where each stock's weight is its market capitalisation (or free-float market cap) divided by the total. The most popular method; adjusts automatically for splits, making it ideal for index funds and derivatives.

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Original explanatory writing based on the official NISM workbook for Series XIX-E, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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