Can the price of a stock increase just by the virtue of it being included in an Index?
The answer is yes!
The inclusion of a particular stock in an index can lead to an increase in the price of the stock.
But before we explain how this can happen, we need to understand what a Stock Market Index is.
A Stock Market Index is an indicator of Market Momentum. An Index is created by selecting stocks that are representative of the entire market or a specific sector of the market. A weightage is then assigned to each individual stock that comprise the Index. The index tracks the changes in Market Capitalization of the stocks it represents.
For example, the Nifty tracks the movement of the top 50 companies listed on the National Stock Exchange (NSE) of India.
Now, that we have had an understanding of what a Stock Market Index is, we need to look at what Exchange Traded Funds (ETF) are.
Exchange Traded Funds (ETFs) are securities that track the performance of a commodity (e.g Gold ETF) or an Index (broad-market like the NIFTY or sectoral Index like the Bank NIFTY) and are traded on a stock exchange.
Index Funds are ETFs that track the performance of an Index by investing in the basket of stocks, that represent the particular index; in proportion to their weightage in the Index.
Index Funds are similar to Mutual Funds in many aspects. However, a key difference between the two is the fact that a Mutual Fund will almost always have a fund management team who are responsible for making buy and sell decisions on behalf of the fund.
In contrast, an Index fund simply invests in constituent stocks of an Index and does not need an active Fund Management team.
The only time when Index Funds buy or sell stocks is when there is a rebalancing or reconstitution of the Index itself.
By Rebalancing of an Index, we mean changes in the weights of the constituent securities in the index.
Reconstitution of an Index is the process of changing the constituent securities in an index. Each Index has a defined set of criteria, based on which the constituent securities are selected. When a security no longer meets the criteria, the same is excluded and new securities are included.
The fact that Index funds do not actively buy or sell securities, is the reason why they are also referred to as Passive funds.
Now let us come back to the question of how and why the inclusion of a particular stock/security in an index can lead to an increase in the price of the security.
The answer to this is simple.
When a stock is included in an Index, all Passive Index Funds that track the Index will now have to buy the stock to include the same in their portfolio and sell the securities that no longer form part of the Index.
All this buying from the passive funds, creates demand for the stock in the market, thus pushing the price of the stock upwards (other things being equal).
Simple economics!
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Hope you liked our presentation and found it informative!
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