Introduction
A constituent is a part of the market index. It is a company stock that, when aggregated with others constituents, forms an index. The value of an index is determined by aggregating the prices and considering the weightage of all the constituents in that index. Every constituent needs to fulfil certain criteria (like market cap, liquidity, stock holdings, stock price, etc) to become a part of an index. For example, the BSE Sensex is a widely known index that includes the 30 largest stocks that are listed on the Bombay Stock Exchange. NSE Nifty 50 is another popular Indian index that comprises 50 highly valued stocks that are being traded on the National Stock Exchange. All these company stocks which make up the index and determine its value are called constituents.
Importance of Constituents
Constituents make up the index which is quite important to track and analyse the performance of stocks being traded in a particular market or its development. There are multiple metrics as well as investment modes that are dependent on indexes (like mutual funds and index funds). Some mutual funds might be heavily influenced by the indexes while others (index funds) simply use the same asset allocation, hence their performance is deeply linked to how well the constituents of that particular indexes’ constituents are performing.
The constituents also receive greater exposure and credibility on being a part of a particular index. This might also lead to an increase in the prices of the constituent. On becoming a part of a particular index, a firm’s stocks also gain the attention of the mutual funds following that index as they will most likely invest in the firm.
Constituents are quite important in the investment field as they make up an index that can help keep track of different sectors (or the economy). The index provides investors and portfolio managers with a benchmark that enables them to evaluate their own performance (a fund manager who is consistently outperforming the index is known to be “beating the market”).
Requirements of Constituents
Like every other shortlisting process, every index has certain criteria which a constituent needs to fulfil in order to become a part of that index. The conditions on which a constituent can become a part of an index can vary from one index to another. Each constituent needs to fulfil these prerequisites in order to become a part of that index to ensure that the latter can correctly showcase the performance of the concerned industry. Every constituent has a certain weightage within the index and impacts its overall value. Major indexes like the NYSE Composite Index and Nasdaq Composite Index track the performance of all the equities listed on these stock exchanges to provide a clearer view of the market trends and conditions. The weight of a constituent in the index is equivalent to its price and its weightage on the index depends on market capitalization. The movement of the index takes into consideration the price return as well as the dividend yield of its constituents. Smaller indexes that keep track of the performance of particular sectors are often more accurate than the large ones but as a market index reduces, the requirements to become a part of it also change as there is a reduction in market cap size and narrowing down of the sector to which the constituents belong to. While there are multiple ways in which criteria can be built, these are the most commonly found criteria using which indexes shortlist constituents:
Price-weighted indexes: These indexes pick constituents who have a higher share price as that is given the most weightage while determining the price of the index. It can be thought of as a portfolio that comprises one share of each constituent stock. It isn’t much preferred as a benchmark for portfolio managers and passive investment strategies as a stock split can result in a reduction of its weight despite no meaningful change in the fundamentals of the stock. For instance, the Dow Jomes Industrial Average consists of popular companies (from various industries) and each constituent has a weight proportional to its price.
Market value-weighted indexes: Indexes that select constituents on basis of market value tend to give more weightage to constituents with higher market capitalization. These indexes tend to prefer large companies and often perform well when large caps outperform small or mid caps. They can also thrive well in momentum-driven markets.
Equal-weighted indexes: An alternative to these indexes is equal-weighted indexes. These indexes don’t put weightage on the basis of price or market cap and treat all members equally. Instead of picking the large companies, these indexes assign the same weightage to every constituent. These tend to perform better than market cap-weighted indexes An example of this is the Standard & Poor’s 500 Equal Weight Exchange Traded Fund which assigns equal weightage to each of its 500 constituents in terms of mid or small cap stocks and doesn’t require excessive valuations during momentum-driven markets.
Free-floated adjusted market cap weighted indexes: These indices modify the market-cap index weights by considering the strategically held shares (that aren’t available to the general public) of each constituent. These can be held by the government, founders, employees, etc. It can also take into account the foreign ownership limits imposed by the government for free-float adjustments. It’s often difficult to predict the movement of these indexes (in general) as different free-float adjustment methods can produce different results.
These indexes have review committees that keep a check on the performance of the constituents and re-evaluate the index to replace the ones that no longer meet the listing criteria with those that do.
Benefits of constituents and index funds
The reason why constituents and indexes hold an important value in determining and tracking the progress of specific sectors or markets is that these can be used to generate good investments. Index based funds (index funds like Standard & Poor’s 500) help investors diversify their portfolios and reduce exposure to risk. These funds mimic the position and performance of a particular index, hence their success heavily depends on the indexes’ value, which in turn depends on how well the constituents are performing.
