Constructing an index is similar to constructing and managing a portfolio of securities. The steps involved in the construction of an index are as follows:
a. Target Market Selection. The market selection can be made based on many factors such as:
i. Asset class, i.e. depending upon, whether the constituent assets contain equities, fixed-income, real-assets, etc.
ii. Geographic region, i.e. it could be based on the location/orientation of securities from different countries or regions such as the U.S., U.K., Canada, Japan, etc.
iii. Exchange, i.e. the index can be constructed for the securities listed on different indexes such as New York, London, Frankfurt, etc.
iv. Other characteristics, such as sector, industry, size, etc. of the security.
b. Security Selection. Once the market is selected, then we need to decide the securities that are going to be a part of the index. Whether the index is going to have all the securities from the target market or just a sample of securities that represent the market? Whether the index is going to have a fixed number of securities, such as the S&P 500 Index, or a variable number such as TOPIX?
c. Weightings. Once the securities selection is made then we have to decide the amount of weight that each such security is going to have in the index. The methods of providing weightings to different securities in the index are discussed in the next section.
d. Rebalancing. Then the constructor has to decide about the frequency of rebalancing the index, whether it is going to be done once a month or in the year, etc.
e. Reconstitution. This involves reconstructing the index by adding the new constituent securities and removing a few.