Methodology Matters | S&P Dow Jones Indices (2024)

Unless indices use precisely the same methodology, their actual returns will differ, sometimes significantly. So understanding the methodology an index uses, and the impact it can have on performance, is especially important for the growing number of investors whose holdings include index-based investments.

Broadly speaking, an index methodology is a set of rules or criteria that govern an index’s creation, calculation, and maintenance. The rules determine the securities that are eligible for inclusion in the index, the formulas by which the index value is calculated, the process for modifying the components, and a timetable for updates.

Index methodologies can be complex, but they’re not a mystery. In fact, one of the core characteristics of an index methodology is typically transparency. Most prominent index providers make the methodologies for their indices publicly available, ensuring that the indices can be replicated.

From an investor’s perspective, it is important to realize that an index’s methodology is the blueprint that ultimately determines the index’s characteristics and the performance it will deliver. That’s why, in selecting among ETFs whose underlying indices appear to represent the same exposure, a potential investor should understand the key elements of each index’s methodology. Only then can an educated decision be made about which ETF to choose based on individual investment goals.

Eligibility and Selection Criteria

Eligibility and selection criteria determine which securities are eligible for and ultimately included in an index. Typical criteria include a security’s market cap, the location of the issuer’s corporate headquarters, and the currency or currencies in which the security is denominated. For example, the criteria might specify that all U.S. stocks with a market cap of USD 5 billion will be eligible for the index, or that only technology stocks are eligible.

Liquidity, a measure of how frequently an asset or security is traded, is often a key criterion of eligibility. If the intended use of an index is to underlie an investment product, liquidity may be a key determinant of how readily a product provider wishing to replicate the index could purchase the asset for the product’s portfolio. As a result, illiquid or thinly traded securities that might otherwise be eligible for an index may be excluded.

Depending on the intended use and intended exposure of an index, the criteria might screen for other factors, including financial characteristics or fundamentals, such as price-to-earnings ratio or dividend yield.

The types of criteria that can be used to screen stocks vary widely. Shariah indices, for example, exclude stocks from companies that produce goods or services that may be unacceptable to Muslim investors. Sustainability indices may exclude companies that fail to meet minimum standards based on environmental criteria.

Once a set of eligible assets has been identified, many index methodologies rank them based on one or more selection criteria, and choose only the top qualifiers as index components. For example, the S&P 500 generally selects the largest U.S. securities based on market cap, once other eligibility criteria are met.

Making the Cut:

How stocks are selected for the Dow Jones U.S. Dividend 100 Index

To understand how weighting works, consider the Dow Jones Industrial Average^®, which uses a very simple weighting method: price weighting. If Merck, a constituent of The Dow^®, had a share price of USD 90, and the sum of the share prices of all DJIA component stocks was USD 4,300, then the weight of Merck in The Dow would be USD 90/USD 4,300 = 2.1%. If Visa, another DJIA component, had a share price of USD 180, it would have a weight of USD 180/USD 4,300 = 4.2%. Because the weight of Visa is twice that of Merck, a 10% change in the share price of Visa would have twice the impact on the performance of The Dow that a 10% change in the share price of Merck would.

While price weighting is the simplest type of weighting method, it is not commonly used. The more typical weighting methodologies account for factors other than stock prices.

How Does Weighting Impact an Index?

See how an index’s composition changes depending on how it’s weighted.

If an index is equal-weighted, all component stocks have the same impact on index performance.

If the index was price-weighted, Company A would have the greatest influence on index performance, because it has the highest stock price.

If the index was market-cap weighted, Company B would impact the index performance the most, since it has the largest market capitalization.

How Is an Index Value Calculated?

Click to reveal how a typical market-cap index might be calculated.

The divisor is key to index calculation. It’s an arbitrary, though usually publicly available, number that is set at the time an index is launched. The divisor is used as the denominator in the equation for calculating index level where the numerator is the cumulative market value of the securities in the index. Because the numerator value can easily be trillions of dollars, the first thing the divisor does is to scale, or reduce, that figure to a comprehensible number.

Even more importantly, the divisor is the means for maintaining a continuous measure of market valuation, even as the list of index components is modified and the floating shares for various securities are adjusted. This continuity is possible because the divisor is regularly adjusted to compensate for any changes other than share prices that would affect the index value. Such changes may include rights offerings, spin-offs, and special dividend payments.

In addition, any adjustment to the divisor is made after the close of trading. As a result, the closing value of the index before the change is the same as the opening value on the next trading day, assuming that the prices of the component securities stay the same.

Divisor adjustments to equal-weighted and price-weighted indices differ from those for cap-weighted indices. However, all of these indices adhere to the principle of maintaining a constant index level irrespective of changes to index components. For example, in a market-cap-weighted index, an adjustment isn’t required for stock splits because the market value of the security remains the same. However, with a price-weighted index, an adjustment is required because price—which might be half or less of what it was before the split—is the operative factor.

This requires changes in the roster of index components over time, with some securities added and others dropped. In addition, share counts typically need to be updated to reflect the actual number of shares available for trading.

For most indices, security deletions and additions happen concurrently, during regular rebalancing, typically scheduled on a quarterly or annual basis. At that time, the index provider essentially repeats the selection process to choose the securities that best meet the criteria established in the methodology.

Most index deletions take place when a company fails to meet the eligibility requirements of an index, or becomes outranked by other companies based on the index’s selection criteria. Other deletions are required because the issuing company has been acquired, taken private, or merged with another company. In each case, the basis for removal is made clear.

Additionally, most index methodologies provide for securities to be dropped from an index between scheduled reviews in the event of a major corporate action, such as a delisting or bankruptcy.