Exploring the latest fashions
There are many types of indexes – but we are really talking about indexes that help us keep a score rather than the ones you find at the back of a textbook and, in particular, we are talking about equity indexes. There are now more equity indexes than there are stocks listed on the world equity exchanges, so we will point out those that are useful (given there are a few that are not so useful).
There is a debate about whether the plural of index is “indexes” or “indices”. When it comes to people working in finance, we often take cues from the Financial Times which is why we write currencies in a lower case, for example, the American currency becomes the dollar. In the present case, the FT favours indices, but MSCI, a leading index provider, prefers indexes. Both can be used, but we will stick with indexes.
An index provides a standardised score based on a group of inputs. These can be the prices of equities, bonds or some other object. Indexes can be used to track performance in a standardised way. An index can also represent a benchmark against which a thing may be measured. Some commonly known indexes are very good benchmarks whilst others are not so useful, for reasons we will go into.
Benchmarks like S&P 500, the FTSE 100 and the Stoxx Europe 600 index are very helpful and widely used benchmarks of equities in the US, UK and European markets. They are helpful because they are broad and representative of the universe of stocks you might invest in across a territory. There are also “all share” indexes which include the very smallest stocks on a stock market. These are not often used as a benchmark
because it can he hard and very expensive for a manager to invest in the smallest stocks.
An investor should be on their guard because there are price indexes and total return versions of these indexes. The total return indexes include dividends paid and assumes the dividends are reinvested. The price only indexes ignore dividends and have a much lower return and should, therefore, not be used as a benchmark. The price indexes are, however, occasionally used by financial promoters because they are easier to beat than the total return indexes, and any financial products based on price only indexes should probably be avoided.
The total return indexes come in a variety of favours. There are “net total return” or “NTR” indexes which assume 30% withholding taxes are paid on any dividend or “total return” which assume no taxes are paid. The majority of investors pay some tax, so the most relevant indexes are the net total return indexes. You can probably pay a lower rate of withholding tax than the US’s 30% rate, but this simplifies and standardises the measures.
The S&P 500, the FTSE and Stoxx Europe 600 are market capitalisation indexes. That is the size of a company in an index is a function of its share price times the number of shares, so the most valuable companies are the biggest constituents of the index. This number is adjusted for the free float, so that long-term founding family or
government holdings are excluded. Thus, if a government holds 80% of a company for whatever reason, only 20% of the company goes in the index.
Even mainstream, representative, net total return indexes can be hard for a manager to follow as the index compilers assume that all dividends are immediately received and reinvested without any cost. This assumption is a necessary myth. The reality is that dividends can take some time to be received and reinvested, so even the best managers will suffer from some cash drag over time.
There are famous “price” indexes which are not suitable for benchmarks. This includes Japan’s Nikkei 225 index and the Dow Jones Industrial Average 30 index. These indexes just look at the share price and do not take into account how many shares are outstanding or the free float. This means the share with the highest nominal share price gets a bigger weighting. In the S&P 500 the biggest stock is Nvidia, with a market cap $4.2T, whereas in the Dow Jones 30 the biggest stock is Goldman Sachs, market cap $217Bn. Goldman is bigger in the Dow Jones because its share price is $715 whereas the share price of Nvidia is $175.
The same applies to Nikkei 225. The biggest stock in the representative, market cap weighted TOPIX, index is the car giant Toyota, but the biggest stock in the Nikkei 225 is Fast Retailing – the owner of Uniqlo. Both are great companies, but Toyota’s market cap is 2.5 times the size of Fast Retailing. However, Toyota only has a share price of 2,500 yen whereas Fast Retailing has a share price of 44,500 yen. Consequently, the TOPIX index and Nikkei index can show different daily returns depending upon whether Uniqlo had a good day or not.
You may be now able to appreciate that the subject of indexes is quite a big one and we have mentioned a few things which will hopefully enable you ask a few pointed questions the next time you meet your investment manager. The key words to remember are broad, representative, market cap weighted and net total return.
Remember those and you should boost your investment health, and sleep better at night.
Please be aware that the value of investments may go up or down and you may receive back less than you invested originally. Past performance is not a guide to the future.
This document contains general information only and does not provide any advice or guidance specific to your personal circumstances.
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