Stock Indices: An NDX Primer

What’s An Index?

You know the answer to this already, even if you’re not aware of their constituent components or inner machinations. The S&P 500 is an index. The NASDAQ Composite is an index. The FTSE 100, the Hang Seng, the JSE 40, the NIFTY 50… they’re all indices. These names get thrown around a lot daily. If you’ve got any sort of investment vehicle for your pension, you’re likely in more than one already.

What Goes Into An Index?

When an index is first created, there are a handful of decisions that need to be made regarding it’s inner workings: specifically a) the list of what it’s going to be tracking, and b) the prominence of each member in that list.

How Is An Index Weighted?

Now we know which tokens are going to make it in to the pool, there’s a separate decision to be made about the weightings — the slice of the pie allocated to each constituent member. There are a few ways to do this:

  • Equal-Weighted: if there are 10 members of an index, you assign a weight of 10% to each. Indices weighted equally will give equal prominence to giants like Apple and Four Seasons Total Landscaping, and are traditionally (in brick-and-mortar indices) considered higher-risk/higher-return due to the potential for rapid expansion by the smaller companies contained therein. There are a bunch of S&P 500 equal-weighted indices out there, so they’re not uncommon.
  • Price-Weighted: if company A has a stock price of $20 and company B has a stock price of $10, the weighting would be split 2:1 in favour of the former. This is the method used by the Dow Jones Industrial Average, and has the benefit of simplicity, but the downside that weights assigned are somewhat arbitrary — two companies might be worth the same amount, but if one has five times as many total shares as the other (and hence the stock price varies by a similar proportion), that difference will be reflected.
  • Market-Capitalisation-Weighted: we’ve already talked about this above — weights are determined based on the overall value of the company/token. This is by far the most commonly used weighting mechanism for indices — the ‘normal’ S&P 500 uses it, for example.

Why Are Indices Rebalanced?

There’s not much point in buying these things if we’re expecting the price to stay stable, though. The whole reason we’re doing this is because we’re expecting the prices of the components to go up (crypto never goes down, we know this by now). As they do, the weightings of what’s in your index will shift away from their targets.

Finally, Why Hold An Index At All?

So, at the end of all this (or if you just scrolled down)… why hold an index? Fundamentally, this comes down to pure convenience — if you’re bullish on a particular sector, then purchasing an index tracker acts as a proxy that gives you exposure to said sector without having to purchase the constituent stocks yourself, incurring fees (viz. gas, in our context) for each.

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Dr Laurence E. Day

Dr Laurence E. Day

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Functional programmer, decentralised financier, bad joke maker. Previously Intel Labs, Standard Chartered Bank, Arboreum. BSc Maths, MSc Fineng, PhD Compsci.