Market indices

A stock market index (such as the FTSE 100, Dow Jones, Nikkei, Hang Seng, etc.) tracks the movement of a market as a whole. Other indices track the performance of sectors, regions and different classes of security.

The basic data used to calculate an index are securities prices, but the calculation of an index means weighting price changes appropriately to reflect company size and the availability of securities to investors.

Indices are often used as benchmarks of fund and portfolio performance. This can encourage cautious money managers to closet track the indices. As well as providing an indicator of markets, indices are used as the basis for constructing tracker funds. There are also derivatives whose value depends on indices.

Index calculation

Most equity indices track the change in aggregate market cap of the shares included in that index. The number is arrived at by dividing the total market cap by a divisor. This divisor is a number that was set (to provide a convenient index level such as a 100 or 1000) when the index was started and which is periodically adjusted.

Another way of looking at this is that the change in the index is the weighted average of the changes in the share prices of companies in the index, the weights used being the market caps of the companies.

Most indices, including almost all the FTSE indices, are calculated this way.

Older indices were calculated more simply by adding share prices together and then dividing by a fixed factor. The effect of this is that the index is weighted by share price. A movement in a higher priced share will have a greater impact than a movement of the same proportionate size in a lower priced share, regardless of the relative size of the companies.

The obvious in-correctness of this compared to market cap weighting means that it is now rarely used. The only index of any importance calculated this way is the Dow Jones Industrial Average. This is a very good reason to use another index (such as the S & P 500) instead of the Dow.

Style indices and other fundamentally weighted indices use different weightings. In the case of style indices, this reflects their purpose. The use of fundamentally weighted indices in other roles has been controversial.

To keep the indices meaningful, adjustments are made when a company issues new shares or purchases shares and when companies are added or deleted from an index. Unfortunately, this itself creates more biases in indices.

Investing in indices

Investors who want exposure to indices have a number of options. The most obvious is to simply buy every security in the index, at the appropriate weight. The problems with that are the costs of trading in so many securities, with some rebalancing needed very time the composition of the index changes, and extensive rebalancing sometimes required when the index rules change.

An alternative is to create a portfolio that has returns that are strongly correlated with the index, but containing fewer securities. This is what index tracker funds do. This obviously creates some risk of not performing exactly in line with the index, but this tracking error can be kept very small.

Another alternative is to buy index futures. This gives highly geared exposure, but this can be diluted by holding cash (i.e. a portfolio of cash and index futures will give the same returns as the index — rather like a synthetic security).

Important indices

  • FTSE 100: an index that includes the 100 largest UK listed companies which covers about 80% of UK market cap.
  • FTSE 250: the next 250 largest companies
  • FTSE 350: includes all companies in the above two indices: covers about 90% of total UK market cap
  • FTSE Techmark: a technology index in which companies are included based on a broad definition of technology that includes pharmaceutical and medical device manufacturers as well as IT, electronics and engineering companies
  • FTSE Eurotrack: a family of indices at cover European markets as a whole
  • CAC-40: the main (most widely used) index for the Paris borse
  • DAX: the most widely used German index
  • Dow Jones: the most widely used US index, but badly flawed
  • S & P 500: constituents are the 500 largest US listed companies
  • Russell 2000: a broad US index
  • Nikkei:the main index for the Tokyo stock exchange
  • Hang Seng: the main index for Hong Kong
  • MSCI: a family of indices most widely used for emerging markets