Are your investments doing well? Without the right measuring stick, you may never know
“The FTSE 100 was up 62 points today on the back of positive economic data”
If you’ve ever heard anything like this on the news, they’re referring to what’s known as a stock market index. As a Financial Planner, it’s important for me to understand how this benchmark relates to my client’s investments, when to use it and when to ignore it. When investing for yourself, it’s important that you understand this as well.
I’m going to cover what an index actually is, how they differ around the world, and why they’re important when it comes to your investments.
An index is a basket of investments that have been selected to represent a particular stock exchange or market sector. There are thousands of indexes around the world based on a multitude of different assets in different countries. These range from huge stock indexes like the S&P 500 with a market capitalization (value) of over $30 Trillion to the world’s smallest index, the Trop X in Seychelles with only 24 stocks listed.
In its simplest form, an index is just a list that a company or organisation puts together. These various different index making companies will take different approaches to how they work out who is going to be on their list. This is an important point to remember. An index is just made up and managed by a company. If I wanted to, I could start the Jason Mountford Cool Logo 50 Index. I’d include the 50 coolest company logos in the world, and if a company changed theirs to something less cool then I could take them out of the index. I don’t know how valuable this would be for investors but who knows!
Many indexes, like the FTSE 100 in the UK, are based purely on the market capitalisation of the companies on that list.
Market capitalisation is the term used for the value of a particular company based on its share price. If a company has 100 shares issued out, with a current value of £1.00 per share, its market capitalisation is £100. If those shares go up to £1.50 then the market cap would go up to £150.
The FTSE 100 therefore is made of the 100 largest companies based purely on their stock market value. If the 100th company in the index has a fall in the value of their shares, they may fall out of the index and be replaced by the company that was number 101 on the list.
This list is given a weighted average and the movement of the overall index is worked out based on whether the average move for the shares within it was up or down.
Most indexes like this are also weighted based on how far up the list you go. For example, as of 22 June 2020, Unilever was the largest company listed on the London Stock Exchange. Because of this, the FTSE 100 Index will put more value on the movement of the Unilever than of ITV, who is number 100 on the list that same day.
Most indexes will use this market cap method to calculate which shares are listed on the index. In many countries, the largest index simply represents the biggest, most valuable companies on that particular stock exchange.
There are some that operate slightly differently to this. The most obvious example is the largest stock market index in the world! The S&P 500 is operated by Standard and Poor’s. Whilst market cap is an important requirement for listing on the S&P 500, the final decision is actually made by a committee.
As well as market cap, the committee considers things like the quality and stability of a company’s earnings, and the liquidity or how easy it is to buy and sell shares in the company. A recent example of a company that has not been accepted on to the S&P 500 because of these additional requirements is Tesla.
Based on market cap alone, Tesla well and truly meets the criteria. The S&P 500 requires that a company have a market cap of over $8.2 Billion, and Tesla’s market cap as of today is almost $350 Billion! The committee had some concerns around the stability of Tesla’s earnings and for that reason have left them out of the index for the time being.
Whichever way an index is built, the end result is broadly the same. The movement of an index broadly represents the average movement of a particular stock market or sector. If the FTSE 100 goes up, then generally speaking UK shares have gone up. If the Nikkei 225 goes down, then Japanese shares have, on average, gone down.
One of the key reasons why having an index is important is because it provides a benchmark for investment managers and investors to measure their performance against. If your UK share portfolio has provided you with a return of 8%, you might be pretty happy as you’ve made a good return. However, if the FTSE 100 has provided a return of 22% over that same period, all of a sudden it doesn’t look quite so good.
By having an overview of what the stock market as a whole has done, it makes it easier to assess whether we need to be making any changes within our portfolio. Comparing the returns is one aspect, but equally important is comparing the volatility. If we are achieving a similar level of return to the FTSE 100 with our UK share portfolio, but our portfolio is way more volatile, then something needs to be adjusted.
A key factor to remember when using an index as a benchmark is to make sure we are comparing apples with apples. If you hold a multi-asset portfolio that includes UK shares, overseas shares, gilts, bonds and cash, it’s not appropriate to compare this to the FTSE 100 which is comprised only of UK shares.
To compare this properly you would need to compare each individual part of your portfolio to the relevant index. Alternatively, there are also multi-asset indexes that do this for you. The important thing is finding the right index that best matches your aims and objectives with your portfolio, to ensure you are using the right measuring stick.
This benchmark has also led to one of the biggest divides in professional investment management. It’s like the Montagues and the Capulets, Marmite vs Vegemite. You are either on one side or the other!
The issue I’m talking about is passive vs active investing. A passive investment will basically track an index. Going back to our UK shares, a passive investment fund would invest in every company in the FSE 100, weighted according to the weighting of the index. This means that the returns you are going to get can generally be considered to be almost identical to the returns of ‘the market’.
There is no manager discretion or choice in this investment method, it is all based on keeping the investment portfolio the same as the index. Because there is no need for extensive research or stock picking, passive investment is very, very cheap. The overall costs for an investment fund investing in the UK can be as low as 0.06%!
Proponents of this method of investing state that it’s actually not possible to beat the market over the long term, once costs are taken into account. This hypothesis was first popularised by an economist from Princeton University, Burton G. Malkiel, in his 1973 book “A Random Walk Down Wall Street.” He suggested through various forms of analysis that a monkey throwing darts at a board was as likely to outperform the market as a professional investment manager!
Obviously, it’s understandable that those professional investment managers don’t exactly agree with this! A large portion of the professional finance community strongly believes that you can outperform the market. Rather than investing passively, these investment managers take an active approach to selecting their investments.
An active manager won’t simply invest in all of the companies in the FTSE 100, but will instead conduct extensive research and analysis and select the shares which they believe are likely to perform better than the index as a whole.
As mentioned this is a controversial area without a precise answer. There are certainly times when an active management approach can outperform investing passively, but it is yet to be proven whether this is possible over the very long term. One thing that is certain is that the costs for active management are higher. There are more resources, more time, and more staff needed to research and pick specific investments, so the costs are more around the 0.50–1.50% range for an investment fund of this type.
Importantly, if you are electing to invest using active management, it becomes very important to closely monitor those investments compared to the relevant index. Crucially, this comparison also needs to be completed after the deduction of all fees and charges.
So why would a company care whether they are listed on an index or not? Well, many probably don’t, but there is a very specific reason why for many CEO’s or Directors, listing on a large index a huge boon.
In fact, when the S&P 500 announced that Tesla wasn’t going to be included on the index, their share price fell by 21% when the market opened. Why? Partly because of the huge popularity of passive investing.
As it currently stands, there are likely to be a lot of professional investment managers who are wary of Tesla. They are an innovative company that is doing things differently, but they have had their fair share of production issues and delays. Their share price has still had a meteoric rise over the past number of years, but many of the world’s largest investment funds will not be investing simply due to the fact that they are not in the S&P 500.
A listing would change all that. If Tesla were to be included in the S&P 500 index, every passive fund which tracks it would need to buy Tesla shares. This increases the competition for the shares which drives the price up, making shareholders (including Elon Musk and other senior executives at Tesla!) wealthier.
Trying to measure your investment portfolio without comparing it to an index is like trying to run your best 5k time without measuring out a course. You need to know the conditions and parameters you are dealing with before you can work out whether you are doing well or not.
It’s really important that when you do this, you pick the right index to make an apple to apple comparison. This will make sure your portfolio stays on track for you to reach your long term financial goals.
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