If you already follow the business news you may know that these indices measure the movement of share prices within the stock market. But what is the importance of these indices, which are the major indices and why should you pay attention to them?
Why indices are important
The major UK indices
Overseas indices
Index trackers and ETFs
Stock market indices are important because they provide an excellent guide to how profitable companies are and, therefore, how healthy the economy is. In simple terms, if investors think the economy is growing they will buy shares as companies are likely to produce better profits. This should result in a rise in a stock market’s index.
If, however, investors believe the economy is going to do badly, they will sell shares as companies are likely to produce poorer profits. This should result in a fall in a stock market’s index.
In reality, a stock market index will rise or fall day to day depending on the latest economic, political and company news that has emerged. Employment figures, retail sales, international trade negotiations, conflicts, new legislation, elections and the forecasts made by major companies can all result in a rise or fall in a stock market’s index. Read more about what influences share prices.
Stock market indices are also used by investors as a way to measure their own performance. If you invest your money in a fund such as a unit trust, investment trust or open ended investment company (OEIC) you will find that the fund manager’s job is to produce better returns than a particular stock market index.
In the UK, the main index used by fund managers to measure their performance is the FTSE All-Share™ But there are a whole host of other indices used by professionals and novices to track the performance of the stock market.
In the UK the main index monitored by investors is the FTSE 100™. This index, which was established in 1984, monitors the performance of the 100 largest companies in the UK.
The index’s focus on the biggest British companies, also known as ‘blue chips’, means it is the one newsreaders and newspapers refer to when they talk about the performance of the stock market. But the strong returns made by certain companies within this index means that in recent years it has become heavily dominated by three major sectors: banks, oils and pharmaceuticals.
At the end of February 2004 these three sectors made up a 46% of the value of the FTSE 100™ index by market capitalisation and this concentration arguably makes it less representative of the British stock market as a whole.
Few British fund managers measure their performance against the FTSE 100™, preferring the broader FTSE All-Share™. This index literally measures the performance of all the shares listed on the London Stock Exchange’s main market. So it includes the FTSE 100™ companies and other medium and smaller companies in a variety of industries such as media, building and construction and technology.
Because of the dominance of a few major British companies, the FTSE All-Share™ is still heavily influenced by the performance of companies in the FTSE 100™. At the end of February 2004, for example, the FTSE 100™ made up 82% of the FTSE All-Share™ index by market capitalisation.
If you want to get the full picture of what is going on in the British stock market you need to not only look at the performance of the FTSE All-Share™ and FTSE 100™ but also the FTSE 250™ index, which covers medium sized firms and the FTSE Small Cap™ index, which covers smaller companies. These indices make up approximately 14% and 4% of the FTSE All Share™ index by market capitalisation but represent more accurately the performance of British industries such as technology, building and construction and media.
There are a wide variety of other indices that measure the performance of specific sectors. The FTSE techMARK™ index, for example, covers the technology companies listed on the Main Market while the AIM™ index covers companies listed on the Alternative Investment Market. Read more about the different UK markets.
Whether you are planning to buy shares listed on overseas markets or not, it is important to be aware of what is happening to other stock markets around the world.
Arguably the overseas market that investors watch more closely than any other is the US. The American market is regarded as so important because the US is the biggest economy in the world and is home to many of the world’s largest companies. So, what happens to the American stock market tends to influence the performance of every other market in the world.
The American index investors will be most familiar with is the American Dow Jones Industrial Average™, which measures the performance of the top 30 companies in the US. Like the FTSE 100™ in the UK, this index is not regarded as truly representative of the American economy and so professional investors tend to follow the S&P 500™ index more closely. The NASDAQ™ index has also become more important to investors as it monitors the performance of the growing technology industry in the US.
European indices are also very important, particularly to UK-based investors, as British companies do a large proportion of their business on the Continent. Among the major European indices to watch are the DAX™, which measures the German stock market, the French CAC-40™, Italian Mibtel™ and Dutch AEX™ and Swiss SMI™.
There are also a number of other major international indices investors watch. These include the Japanese Nikkei 225™ index, the Hong Kong Hang Seng™ index, Singapore’s Straits Times™ index and Thailand’s Bangkok SET™.
In recent years it has become increasingly common for British investors to put money into schemes that track the performance of UK and overseas indices. These schemes have become popular because they do not rely on the skills of individual fund managers to produce returns but instead use computers to match the return produced by the index.
Most of these schemes are set up as unit trusts or open ended investment companies (OEICs) and track the FTSE All-Share™ index. They can be bought through a variety of financial companies, such as banks, fund managers and independent financial advisers. Read more about investing in funds.
More recently the London Stock Exchange has introduced Exchange Traded Funds (ETFs). These schemes work like index tracker funds, giving you access to the performance of specific indices such as the FTSE 100™ or sectors, such as technology. But unlike index tracker funds, ETFs are set up as companies and rather than using computer modelling to track an index, they build portfolios of real shares.
While there should be very little difference between the performance of index tracker funds and ETFs, being set up as companies gives ETFs a real advantage – they can be traded throughout the day like ordinary shares. Index trackers can only be bought and sold at a price set at the end of the day. The annual fees on ETFs are similar to tracker funds. But you will also have to pay stockbrokers’ commission. Read more about ETFs.
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