Index construction
Choosing an index's constituent stocks and deciding its calculation methodology — a trade-off between diversification and liquidity, with the final inclusion call taken by an Index Committee.
In plain language
Every index is a design decision before it is a number. Index construction, in the workbook's words, is all about choosing the index stocks and deciding on the index calculation methodology.
It is one of three jobs in index management. The other two are maintenance — adjusting the index for corporate actions such as bonus, rights, splits, consolidations and mergers — and revision — changing the composition itself, replacing some stocks with new ones. All three are generally done by specialised agencies: BSE indices are managed by Asia Index Pvt Ltd and NSE indices by NSE Indices Limited.
The core tension in construction is simple. More stocks mean more diversification, but every stock you add must also be liquid enough to trade, or the index cannot be replicated or used as an underlying.
How it works
Diversification versus liquidity. A good index is a trade-off between the two. The workbook quantifies the diminishing return on diversification: going from 10 to 20 stocks leads to a sharp reduction in risk; going from 50 to 100 stocks gives very little; going beyond 100 stocks causes almost zero decline. There is little to gain by diversifying beyond a point.
Selection. Stocks are chosen on pre-determined qualitative and quantitative parameters laid down by the Index Construction Managers. A stock that satisfies the eligibility criteria is entitled for inclusion, but generally the final decision of inclusion or removal is taken by a specialised committee known as the Index Committee.
Methodology. Chapter 2 sets out four: market capitalization weighted, free float market capitalization, price-weighted and equal weighted.
Prudential norms for derivatives on non-benchmark indices. Under a SEBI circular dated 30 October 2025, exchanges must apply these to existing non-benchmark indices carrying derivatives:
| Norm | Requirement |
|---|---|
| Constituents | Minimum 14 |
| Top constituent weight | ≤ 20% |
| Combined weight of top 3 | ≤ 45% |
| Weight structure | Descending |
BANKEX (BSE) and FINNIFTY (NSE) were to comply by 31 December 2025 in a single tranche; BANKNIFTY (NSE) by 31 March 2026 in four monthly tranches.
Eligibility of an index for derivatives (Chapter 6, section 6.3) adds a further construction test: at least 80% of the index weight must be in stocks individually eligible for derivatives, and no single ineligible stock may weigh more than 5%.
A worked example
The workbook's four-tranche adjustment (Chapter 2, section 2.5). The top constituent of an index weighs 28% against a target of 20% — an 8% excess to remove in four monthly tranches. Weights are re-evaluated at the start of each tranche, because prices move in between.
| Tranche | Start weight | Calculation | Adjusted weight |
|---|---|---|---|
| Month 1 | 28% | (28 − 20) ÷ 4 = 2% | 26% |
| Month 2 | 25.5% | (25.5 − 20) ÷ 3 = 1.83% | 23.67% |
| Month 3 | 23% | (23 − 19.5) ÷ 2 = 1.75% | 21.25% |
| Month 4 | 20.9% | (20.9 − 18.5) ÷ 1 = 2.4% | 18.5% |
The target itself changed to 19.5% and then 18.5% in months 3 and 4 — the workbook assumes relative price movements shifted the constituent's target weight.
Testing a hypothetical index (illustrative). A sectoral index has 15 stocks. Its top three weigh 22%, 14% and 11%; stocks eligible for derivatives on their own make up 83% of the weight; the largest ineligible stock weighs 6%.
Constituents ≥ 14? 15 → passes
Top constituent ≤ 20%? 22% → fails
Top 3 combined ≤ 45%? 22 + 14 + 11 = 47% → fails
Eligible weight ≥ 80%? 83% → passes
Largest ineligible ≤ 5%? 6% → fails
Three failures. The index is too concentrated in its top stock, and one stock that cannot itself carry derivatives is too heavy. A fund tracking it with Rs 10 crore would have Rs 2.2 crore in a single company.
Why NISM asks about it
Chapter 2, section 2.5 (Index management), defines construction, maintenance and revision, gives the diversification figures and the Index Committee's role, and sets out the October 2025 prudential norms with the tranche table. Chapter 6, section 6.3, gives the 80% and 5% eligibility tests for index derivatives. Expect definition questions distinguishing the three index management tasks, the 14 / 20% / 45% norms, and the diminishing benefit of adding stocks.
Common exam traps
- Construction = choosing stocks + methodology. Maintenance = corporate action adjustments. Revision = changing the composition. The three are routinely swapped in options.
- More stocks is not always better. Beyond 100 stocks the workbook says risk reduction is almost zero.
- The final inclusion or removal decision is the Index Committee's, not the Index Construction Managers'.
- 20% for the top stock, 45% for the top three, minimum 14 constituents — for non-benchmark indices with derivatives.
- 80% eligible weight and no ineligible stock above 5% is a different test, for introducing derivatives on an index.
- Stale by date: the compliance deadlines (31 December 2025 and 31 March 2026) have passed; learn them as the workbook states them.
Where this is taught
- Series VIII · Chapter 2: Understanding Indexintroduced here
- Series V-D · Chapter 14: Understanding Indexintroduced here
Related terms
- Equal weighted indexAn index where every constituent starts with the same weight; as prices move the weights drift apart, so the portfolio must be rebalanced by selling winners and buying losers.
- Free floatThe part of a company's shares readily available for trading — broadly, what is not locked up with promoters. Indices, position limits and MWPL are all measured on it.
- IndexA statistical indicator that tracks a portfolio of securities representing a market or part of it, expressed as a change from a base value — so the percentage move matters, not the number itself.
- Index derivativesDerivative contracts — chiefly index futures and index options — that have a stock index as the underlying asset. In India they are cash settled and used to hedge market risk.
- Market capitalizationThe market value of a company: total shares outstanding multiplied by the current market price. It sets index weights and underpins derivatives eligibility and position limits.
- Price-weighted indexAn index in which each stock counts in proportion to its share price — the sum of prices divided by the number of stocks — so a high-priced share moves it most, whatever the company's size.
- Product Success FrameworkSEBI's exit-eligibility test for index and stock derivatives, based on trading-member participation, trading frequency and turnover, applied after a 6-month gestation period.
- Index inclusion effectThe portfolio and price impact when an index rebalance adds or drops a constituent: full-replication funds must buy the entrant and exit the leaver in full, on the same date, whatever the price.
- Macaulay duration bucketThe duration band an index provider uses to sort bonds — NIFTY bond indices run six such buckets, from Ultra-Short at 3 to 6 months up to Long Duration above 7 years.
- Dollar denominated indexAn index built to measure returns on Indian equity in US dollar terms — NIFTY50 USD restates the NIFTY 50 by the ratio of the base-date exchange rate to the current one.
- Base valueThe starting level an index is set to on its base date — often 100 — from which every later index value is expressed as a change, so the percentage move matters more than the number.
- Descending weight structureA SEBI prudential norm requiring a non-benchmark index used for derivatives to weight its constituents in strictly falling order, so no smaller stock outweighs a larger one.
- Surrogate (pseudo) indexA closely correlated substitute index on another exchange that lets derivatives continue on an index that has itself failed the eligibility review, subject to overlap and correlation conditions.