Indices: Construction, Weighting and Rebalancing
What the exam tests
This domain tests how an index is built and maintained, what a level actually means, and how corporate actions and rebalancing are handled without breaking continuity. JSE indices, free-float methodology and capped weightings are fair game.
Core rules
- A market-capitalisation index weights each constituent by shares in issue multiplied by price. Free-float methodology uses only shares available to outside investors, excluding strategic holdings, treasury shares and locked-up stakes.
- A capped index applies a maximum weight to any one constituent, with the excess redistributed. Capping controls concentration in a market dominated by a few large names.
- Price-weighted indices average prices, so a high-priced share dominates regardless of company size. Equal-weighted indices reset to equal weights periodically and require rebalancing.
- The index divisor is the scaling number that turns aggregate market value into an index level. When a constituent changes, or shares are issued, the divisor is adjusted so the index level is continuous and the change itself creates no movement.
- A price index excludes dividends; a total return index reinvests them. Over long periods the gap is large.
Worked example: free-float market capitalisation
Three constituents, with shares in issue, free float and price:
- A: 100m shares, 80% float, R50 = R4,000m
- B: 200m shares, 50% float, R10 = R1,000m
- C: 50m shares, 100% float, R20 = R1,000m
- Total free-float value = R6,000m, so weights are 66.7%, 16.7% and 16.7%
Using full shares in issue would give A a weight of 100m x R50 = R5,000m out of R7,000m, or 71.4%. The free-float method reduces the concentration that a strategic stake would otherwise create.
Traps that cost marks
- Using total shares in issue when the methodology is free-float weighted.
- Forgetting the divisor adjustment on a constituent change, which would create a fake index move.
- Comparing a price index with a total return index and calling the dividend gap outperformance.