What you will learn: how an index provider decides which companies enter an index, how much each one weighs, and when and why the list changes, so you can read a methodology document and know what your index fund will actually own.
Kavya Iyer (an illustrative profile), 34, a product manager in Hyderabad, started a monthly SIP in a Nifty 50 index fund last year. In March she noticed that one company had left her fund and another had joined, and that the weight of her fund's largest holding had moved even though she had not touched anything. Her question: "If an index fund just copies the index, who decides what the index is, and how often does it change underneath me?"
The short answer is that an index is a published rulebook. A passive fund follows the rulebook; it does not escape it. The how the stock market works lesson introduced free-float market cap with a three-company example. This lesson goes one level deeper: the rules that decide entry, weight, caps and timing.
An index is a rulebook, not a list
Every index provider publishes a methodology document. Whatever the index, the rulebook answers the same six questions:
- Universe: which securities can be considered at all (for example, companies listed or permitted to trade on a particular exchange and domiciled in India).
- Eligibility screens: minimum trading frequency, liquidity, free float and listing history.
- Selection: how eligible stocks are ranked and how many are picked.
- Weighting: how much of the index each stock represents, and any caps.
- Review calendar: how often the list is reconstituted and weights reset, with what notice.
- Maintenance: how mergers, demergers, suspensions and other corporate actions are handled between reviews.
NSE Indices' methodology document (September 2026 edition), for instance, describes the Nifty 50 as a 50-stock, float-adjusted market-capitalisation-weighted index. Eligible stocks must come from the Nifty 100 and be available for trading in NSE's futures and options segment, must have traded on every day of the last six months, and must have an average impact cost of 0.50% or less for 90% of observations for a ₹10 crore basket. Impact cost is the extra percentage you would pay, compared with the midpoint of the best buy and sell prices, to trade that basket in one go. These screens exist so that a fund can actually buy and sell what the index holds without moving prices much.
Free float in practice: the investible weight factor
An index weighted by free-float market cap counts only the shares that are realistically available to ordinary investors. NSE Indices expresses this as an investible weight factor (IWF): the fraction of shares left after removing holdings that are not expected to trade. Its methodology lists more than twenty excluded categories, including promoter and promoter-group holdings, strategic stakes and foreign direct investment, government holdings, private-equity and sovereign-fund stakes, employee welfare trusts, directors and key managerial personnel, and shares under lock-in. IWFs are refreshed from the shareholding patterns companies file with the exchanges every quarter.
Worked example: one company's IWF
Assumptions (illustrative): Deccan Polymers Ltd has 50 crore shares trading at ₹800. Promoters hold 52%, a strategic foreign partner holds 6%, an employee welfare trust holds 1.5%, shares under lock-in are 0.5% and directors hold 0.2%. Mutual funds, foreign portfolio investors and individuals hold the remaining 39.8%.
- Excluded holdings: 52% + 6% + 1.5% + 0.5% + 0.2% = 60.2%.
- IWF = 1 − 0.602 = 0.398.
- Full market cap = 50 crore shares × ₹800 = ₹40,000 crore.
- Free-float market cap = ₹40,000 crore × 0.398 = ₹15,920 crore.
The index "sees" Deccan Polymers as a ₹15,920 crore company, not a ₹40,000 crore one. If the promoter sells 10% of the company to the public through an offer for sale, the IWF rises at the next update and the stock's index weight rises even if the share price does not move. This is one reason weights in Kavya's fund shift without any trading on her part.
Weighting methods and caps
Free-float cap weighting is the most common method for broad indices because it mirrors what the whole market owns and needs little trading to maintain: when a stock's price rises, its weight rises automatically. Other indices deliberately use different rules.
| Method | How weight is set | What it changes | Example of a published rule |
|---|---|---|---|
| Free-float market cap | Share price × shares × IWF | Largest companies dominate; low turnover | Nifty 50, reviewed semi-annually |
| Capped free-float | As above, then no stock above a ceiling | Limits single-stock risk in narrow indices | Most Nifty sectoral indices: 33% per stock, 62% for the top three |
| Equal weight | Every constituent gets 1/N at each reset | More in smaller members; regular trading back to equal | Nifty50 Equal Weight: weights reset quarterly |
| Factor tilt | Free-float cap × a factor score, then capped | Tilts towards a characteristic such as momentum | Nifty200 Momentum 30: cap of the lower of 5% or five times the stock's free-float weight |
Worked example: what a cap does
Assumptions (illustrative): a sector index of eight companies with free-float market caps (₹ lakh crore) of A 8.0, B 3.2, C 2.6, D 2.2, E 1.8, F 1.5, G 1.2 and H 1.0, a total of 21.5. The rulebook caps any stock at 33% and the top three together at 62% at each rebalancing.
- Uncapped weights: A 37.21%, B 14.88%, C 12.09%, D 10.23%, E 8.37%, F 6.98%, G 5.58%, H 4.65%. The top three total 64.19%.
- A is cut to 33%. The 4.21 percentage points removed are shared among the other seven in proportion to their size (each is multiplied by 0.67 ÷ 0.6279, about 1.067).
- Capped weights: A 33.00%, B 15.88%, C 12.90%, D 10.92%, E 8.93%, F 7.44%, G 5.96%, H 4.96%. The top three now total 61.79%, inside the 62% limit, so no second step is needed.
If A then falls 10% while the rest are flat, the uncapped index would fall about 3.72%; the capped index falls about 3.30%. Caps apply only on review dates, though. If A instead rose 20% after rebalancing, its weight would drift to about 37.15% until the next reset brings it back to 33%. A cap is a periodic trim, not a permanent ceiling.
Reconstitution, rebalancing and the review calendar
Two words are often used loosely, but they mean different things:
- Reconstitution changes the membership: companies are added or removed according to the selection rules.
- Rebalancing resets weights for existing members, for example back to equal weight or back under a cap.
For the Nifty 50, the published schedule is a semi-annual review using six months of data ending January and July, with any replacements taking effect from the last trading day of March and September, after four weeks' notice. That is exactly what Kavya saw in March. Equal-weight versions reset weights quarterly, and several factor indices review in June and December.
Rulebooks also limit churn. A new company enters the Nifty 50 only if its average free-float market cap is at least 1.5 times that of the smallest current member, and no more than five companies (10% of the index) may be added in a calendar year, except where a member must leave because it no longer meets eligibility rules. These buffers stop a stock hovering near the cut-off from entering and leaving every six months, which would raise trading costs for every fund tracking the index.
Between reviews, the provider makes ad hoc changes for mergers, demergers, delistings, suspensions or a stock losing futures-and-options eligibility. A demerged company may sit in the index briefly before being reviewed for continued eligibility.
How the index level stays continuous
An index value is the current index market cap divided by a base market cap, multiplied by a base value such as 1,000. When a ₹12,000 crore stock is swapped for an ₹18,000 crore stock, the index market cap jumps by ₹6,000 crore without any price moving. The provider adjusts the base (the divisor) at the same moment so the index level is unchanged. Only price moves, not membership changes, move the index.
What the rules mean for your index fund
SEBI's Master Circular for Mutual Funds (as on 20 March 2026) turns these index events into obligations for the fund:
- An index fund or ETF must invest at least 95% of its total assets in the securities of the index it tracks.
- When index constituents change at a periodic review, an equity index fund or ETF must rebalance its portfolio within 7 calendar days, and the change must be disclosed on the fund house's website on the day it happens.
- Any equity index tracked by an index fund or ETF must have at least 10 stocks, no single stock above 25% (35% for sectoral or thematic indices), and the top three together no more than 65%. Each constituent must have traded on at least 80% of days, with average impact cost of 1% or less, over the previous six months. The fund house checks this at the end of every calendar quarter.
Review days also create predictable trading. Suppose, purely as an illustration, that funds tracking an index hold ₹3,00,000 crore between them and a newly added stock receives a 0.8% weight. Those funds need to buy roughly ₹2,400 crore of it around the effective date. Prices can move before the change as other traders anticipate this demand, and some of that cost shows up as tracking difference, which the next lesson measures.
Finally, an index is usually published in two versions. The price-return index ignores dividends; the total return index (TRI) assumes dividends are reinvested. SEBI requires fund performance to be compared with the TRI because funds receive those dividends. Comparing a fund with the price index makes it look better than it really tracked.
Try this: read your index's rulebook in 20 minutes
- Find the index name in your fund's factsheet or scheme document. The scheme name must include it.
- Open the index provider's methodology document and the index factsheet. Note the universe, number of stocks and weighting method.
- Write down the review months and the cut-off months for data. Mark the next effective date in your calendar so a change in holdings does not surprise you.
- Check for caps: single-stock and top-three limits, and whether they apply only on rebalancing dates.
- From the factsheet, note the weight of the top ten stocks and the largest sector. A high number here is concentration, even in a passive fund.
- Confirm which index version (TRI) your fund reports against, then continue to tracking difference and total cost.
Common questions
Who decides which companies are in an index?
The index provider, applying its published methodology. An index committee typically oversees reviews and exceptional cases, but changes follow stated eligibility, ranking and buffer rules and are announced in advance. Fund houses do not choose the constituents of the index they track.
Why did a company leave my index when its share price was still high?
Membership depends on ranking and eligibility, not on recent price gains alone. A company can be replaced because others grew larger, its free float fell, its liquidity or trading frequency slipped, it lost futures-and-options eligibility, or a merger or demerger changed it.
Is a free-float weighted index the same as a market-cap weighted index?
Not quite. Full market cap counts every share. Free-float weighting multiplies by the IWF, so companies with large promoter or government holdings carry less weight than their full size suggests.
Can a single stock become too big in an index fund?
SEBI's limits apply to the index a fund may track: 25% for a single stock in broad indices and 35% in sectoral or thematic ones, with 65% for the top three. Many providers set tighter caps, but weights can drift above a cap between rebalancing dates.
Where to go next
- Tracking difference, tracking error and total cost to measure how closely a fund follows its index.
- Mutual-fund types for where index funds and ETFs sit among scheme categories.
- Building a passive core for choosing between broad, narrow and factor indices.
- Further reading: how to read a mutual fund factsheet.