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Part III: Index Mechanics

Investment

How does index investing work, and what are the benefits to clients? Index investing provides low-cost investments in markets.

Market indexes. You read about them all the time, such as when the FTSE 100 broke above its 2000 highs in 2015 and again in 2016 when it broke 7000. In our last piece, we explored what those points measure (not much in reality), which isn’t always what you might guess. Today, we have a closer look at the mechanics of indexing to understand better why they do what they do.

The Birth of Indexing

When you hear the term “stock index,” you’re in good company if the first thing that comes to mind is the FTSE 100 Index. We’ll talk more about index investing in our next piece, but we’ll note here that, despite its familiarity, the FTSE 100 is a babe in the woods compared to the world’s first index. (It only began in 1984); that honour goes to the Dow.

The Grand Old Dow

As described in “Capital Ideas” by Peter Bernstein:

“The first Dow Jones Average appeared in the Afternoon News Letter on July 3, 1884. It consisted of the closing prices of eleven companies: nine railroads and two industrials. [Charles] Dow’s idea was to provide an overall measure of the performance of active companies at a time when an average day’s activity on the New York Stock Exchange was about 250,000 shares.”

Eleven companies and nine railroads wouldn’t make for much of a market proxy these days! And yet the Dow still only tracks 30 stocks, as it has since 1928. Plus, it still uses mostly the same methods for tracking them. James Mackintosh, a senior market columnist for The Wall Street Journal (the effective birthplace of the Dow): “It’s time to ditch the Dow. After 120 years, the venerable Dow Jones Industrial Average is an embarrassing anachronism, abandoned by professionals and beloved only by a media that mostly knows no better. It needs to be updated or, better, replaced.”

And yet, despite its flaws, the Dow persists. Markets are made of people, and people can be sentimental about their past. More pragmatically, the Dow serves as a time capsule, offering a historical perspective no other index can match. It’s also just plain familiar. As its parent company, the S&P Dow Jones Indices, says, “It is understandable to most people.”

 

How Do Indexes Get Built?

What about all those other indexes? New ones come when an indexer devises a supposedly better mousetrap for tracking market performance. If enough participants accept the new method, an index is born.

That’s how free markets work, and it sounds simple enough. But if we have a closer look at the various ways indexers track their slices of the market, what may seem clear at a glance is often seething with complexities just under the surface. Here are some (not all!) of how various indexes are sliced and diced.

Which Weighting?

How much weight should an index give to each of its holdings? For example, in the FTSE 100, should the returns delivered by Royal Mail (0.23% weight) hold the same significance as those from HSBC (7.3%)?

·        The Dow is price-weighted, giving each company a varying weight based on its higher or lower share price. As Mackintosh explained, “Share prices are arbitrary, as they depend on how many shares are issued; some companies have very high prices, which give them more influence on the Dow, even though they may be less valuable overall.”

·        Market-cap weighting is the most common weighting used by the most familiar global indexes, such as the FTSE All Share. It factors in outstanding shares and current share price to give more weight to the bigger players and less to the smaller fry.

·        Some indexes are equal-weighted, giving each holding, large or small, equal importance in the final tally. For example, there’s an equally weighted version of the FTSE 100, in which each company is weighted at 1% of the index total, rebalanced quarterly.

There are many other variations on these themes. The point is that indexes using different weightings can reach significantly different conclusions about the performance of the same market slice.

Widely Inclusive or Highly Representative?

How many individual securities does an index need to track to correctly reflect its target market?

·        As mentioned, the FTSE 100 represents thousands of publicly traded U.K. stocks. A throw-back to simpler times, it’s unlikely you’ll see other popular indexes built on such modest samples. In its defence, the FTSE favours heavily and frequently traded stocks, so prices are timely and real … at least for the 100 stocks it’s tracking.

·        At the other end of the scale, the FTSE All Share tracks 627 stocks, and some track thousands of shares.

·        The S&P 500 falls somewhere in between, tracking around (not always precisely) 500 publicly traded U.S. securities.

Tracking a Narrow Slice or a Mixed Bag?

What makes up “a market,” anyway? Consider these possibilities:

·        If an index tracks any asset market, should that include real estate companies too?

· If its makeup tends to include a heavier allocation to, say, value versus growth stocks or commodities compared to Industrial stocks, how does that influence its relative results … and is it a deliberate or accidental tilt?

·        Is an index broadly covering diverse sectors (such as representative industries or regions) or is its focus intentionally concentrated?

·        If it’s tracking bonds, are they corporate and municipal bonds, or just one or the other?

The Use and Abuse of Indexing

How well do you know what your index is up to? Remember, in Part I of this series, we described how every index is a model – imperfect by definition. How might each index’s inevitable idiosyncrasies influence the accuracy of its outcomes?

We’ve just touched on a few questions an indexer must address. Like the proverbial onion, many more layers could be peeled away, and the deeper you go, the finer the nuances become.

One practical conclusion is that some indexes are much easier to translate into investable index funds. In addition, some lend themselves better than others to a sound, evidence-based investment strategy. Indexes often may not be the ideal solution for that higher goal. In our next and final segment, we’ll explore the strengths and weaknesses inherent to index investing.

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