How an Index Is Built
An index is a set of rules about what to include and how to weight it. Those rules determine what the index measures and produce mechanical flows when they change.
MadStockAlerts Research · Updated August 28, 2026
What to take away
- Weighting method determines what the index actually describes.
- Capitalisation weighting concentrates in the largest constituents.
- Inclusion and exclusion are decided by a committee or by rules.
- Rebalancing produces large, predictable flows on a known date.
- Two indices of the same market can behave very differently.
MAD Academy Training Video · 0:45
Weighting Decides What You Own
Two indexes of the same 500 companies can behave completely differently, because the weighting rule is the real strategy.
This lesson is part of a Stock Alerts + Tools plan.
The weighting methods
| Method | How it weights | What it describes |
|---|---|---|
| Market capitalisation | By the value of the company | The market's own weighting. The largest names dominate |
| Float-adjusted capitalisation | By the value of tradeable shares | The standard for most major indices |
| Price weighted | By the share price | An artefact. A high price gets a high weight regardless of size |
| Equal weighted | Every constituent the same | The average constituent rather than the largest |
| Fundamental or factor weighted | By a chosen characteristic | A strategy expressed as an index |
The third row describes a widely quoted index and it is worth knowing about. Price weighting means a company whose shares happen to trade at a high price has a larger effect than a much bigger company whose shares trade lower, which measures nothing meaningful.
What capitalisation weighting does over time
A capitalisation-weighted index automatically increases its weight in whatever has risen and reduces it in whatever has fallen. Over a long period of concentrated performance, the index becomes concentrated.
Scroll the chart sideways to see all of it.
Inclusion, and the flows it creates
When a security is added to a widely tracked index, every fund tracking that index must buy it, in proportion to its weight, by the effective date. The reverse happens on removal.
- The flow is large, mechanical and concentrated in a single closing auction.
- It carries no view about the company whatsoever.
- The announcement precedes the effective date, so the move frequently happens before the flow does.
- Reconstitution dates for major indices are published in advance.
This is one of the clearest cases in the library of price movement with no informational content. Volume and price both move substantially, and the cause is a rule rather than anything about the business.
Why two indices differ
Indices of the same market can behave differently because of the rules rather than the market: how many constituents, whether float is adjusted, whether a committee selects members, and how often it rebalances.
That is also why a benchmark has to be chosen deliberately, as the portfolio pillar describes. Comparing against a cap-weighted index and against an equal-weighted one asks two different questions about the same period.
Who decides what goes in
Inclusion is decided either by a published rule or by a committee applying criteria with discretion, and the difference matters for anyone trying to anticipate a change.
| Approach | How membership changes | Predictability |
|---|---|---|
| Rules-based | Automatically, at scheduled reconstitutions | High. The rules are published |
| Committee | At the committee's discretion, against stated criteria | Lower. Judgement is involved |
| Hybrid | Rules define eligibility; a committee selects | Partial |
A rules-based index with a scheduled reconstitution produces the most anticipatable flows, which is why the additions and deletions in such an index are frequently priced in advance of the effective date. A committee-selected index produces announcement-driven moves instead.
Eligibility criteria typically include a domicile, a listing venue, a minimum float, a minimum liquidity level and sometimes a profitability requirement. A company can meet every business criterion and remain ineligible on a structural one, share class structure being the most common.