scrip selection criteria for an Index - Sensex/Nifty

Criteria for selecting stocks of a market index:

1.    Diversification.
2.    Market Capitalization
3.    Liquidity

Diversification: An index should represent the overall market. So the constituents are picked from different sectors. At the time of creating an index they consider the sectors which contributed to the growth of the economy. There would be no benefit if they include stocks of undeveloped sectors. Beyond a certain point adding more stocks would bring zero benefit. That’s why there are no aviation companies in Sensex. In recent years there has been a significant improvement in this sector. In future we can expect a representation from this sector; may not be addition to the existing 30 shares but as a replacement to other stock. We have seen this kind of replacement when DLF was added in place of Dr Reddy’s labs. So they select developed sectors and finalize the number of stocks in an index. This number doesn’t get changed most of the times.

Addition of a stock to a market index is good for that company because index based funds start investing in that stock. This is the reason for rise in price of a stock which gets added and for drop in price of a stock which gets removed.

Market Capitalization:  Usually large cap companies are included in market indexes because they truly represent the market and economy.

Liquidity: This is an important factor while choosing constituents. The market index should be comprised of stocks that are highly liquid in nature. Illiquid stocks may not get traded at the correct price and hence may not reflect the correct market condition and it would be a headache for index funds to buy and sell them. Inclusion of the illiquid stocks actually worsens the index.

   Impact cost is one of the measures of the liquidity of the stock. All stocks having impact cost less than a benchmark value can be considered.
 

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January 3, 2009 | Filed Under Stocks 

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