A market index should reflect the market movements. Since the index funds follow a market index, it should consider only liquid scrips and the active portion of the outstanding shares so that it reflects the market conditions in a better way. So free-float market capitalization method of calculating index value is suitable.
Passive investments such as foreign direct investments are easily replicable. It aids in index flexibility and covers overall market (for market indices) and sectors (for sector indices). It avoids the undue influence of any closely-held (i.e. more promoter holding) large-capitalization stock on the index movement. Free-float market capitalization method is followed by major index providers worldwide. In 2002 MSCI, a leading global index provider, started using Free-float methodology for all its indices. The MSCI India Standard Index, which is followed by Foreign Institutional Investors (FIIs) to track Indian equities, is also based on the Free-float methodology. All other famous world market indices like NASDAQ, FTSE, Dow Jones, S&P, STOXX are also using the Free-float methodology.
Reference: BSE website
Mohan Bhupathiraju
Mohan Bhupathiraju is a co-founder & editor at LastBull.com. Handled multiple projects in BFSI for few of the Forbes top 100 companies. He works in IT industry in the US. Presently working on start up Ideas in Finance & Technology niches.
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