As the soaring dollar slows down and the Footsie and the S&P both look for direction, Brian Tora says it’s stupid to get fixated on indices anyway
With more of a whimper than a bang, the FTSE 100 Share Index eventually clambered over the peak set back in December 1999. And, clinging on with its fingertips, it was not too long before this benchmark index slid back down again. It was all a rather dispiriting sight. There must be many who, like me, had hoped the Footsie would storm past 7000. Well, perhaps it has since then – because you, unlike me, have the blessed gift of hindsight on your side – but as market highs go, it did not look too convincing to me.
Should we really read so much into these truly artificial barriers, though? And how reliable an indicator of a market’s performance is an index anyway?
The misleading nature of these oft quoted benchmarks was brought home to me when I read that at last Apple is to join the Dow Jones Industrial Average. And why not? It is the world’s largest company in terms of market capitalization, after all.
Not that this apparent elevation means a thing. It will be replacing American Telephone & Telegraph – or AT&T – for no better reason than both are considered to be ‘technology stocks’. The Dow Jones is meant to cover all major industrial sectors, but that is where any meaningful representation of what is going on in corporate America ends.
Selection by Bulk
This index is weighted according to share price. In other words, the greater the price of the shares, the greater the influence on index performance. Other indices, like the S&P 500 or our own FTSE 100, are weighted according to market capitalization – a far better representation of what is going on in the underlying market. And just imagine what happens when a company decides to split its shares, effectively halving its share price? Believe me, it has happened.
Not that the way in which our own indices are compiled is without fault. Most people consider the FTSE 100 to be an index of the 100 largest companies listed on the London Stock Exchange. Well, it is, but only sort of. You only gain automatic admission if you rank 90 or higher in capitalization terms, and you will only be expelled if you drop below 110. There is considerable discretion allowed between the rankings 10 either side of 100. And the rules even allow for a few more or less than 100 to be included.
Rules Are Made To Be Broken
This discretion is intended to ensure that companies do not drop in and out of the index on a regular basis, and also to allow changes to be confined to the four quarterly reassessments of the year. But the nature of which companies actually go to make up this magic group is another kettle of fish altogether.
You might wonder how it is that the FTSE 250 and major indices in both Europe and the US managed to set new highs several years ago, while we had to wait more than 15 years to see the Footsie do the same? The problem is twofold. First, it is companies listed here that qualify, regardless of whether their business is conducted in the UK. And of course, such is the prestige of a London listing that all manner of companies have their primary quotation in the square mile.
Curse of the Mega-Zombies
Second – and even more relevant – has been the influence of certain sectors on index performance. Back in the days before the financial meltdown, it was banks that exerted the greatest influence on our indices. So when Northern Rock went to the wall and Lehman Brothers expired, the share prices of these financial Leviathans evaporated. Markets all over took a tumble, of course, but the banks – now beholden to British taxpayers – failed to enjoy the recovery that was seen elsewhere.
Initially, their place was taken by resource stocks – those mining and oil companies that were benefiting from a buoyant China. And when those too turned sour a few years ago, the Footsie foundered. Little wonder that it has taken it so long to play catch up.
At times, the composition of an index has proved highly misleading. Back at the turn of the millennium, a current joke was to ask what do you call a Finnish market tracker? Answer, of course, Nokia. (At one time it represented up to 90% of the Helsinki market’s capitalisation.) And where is Nokia today? It’s all over the papers, and it isn’t good reading.
In the 1980s I was a director of a fund management group that launched a so-called Tiger tracker aimed at replicating the performance of seven small Asian markets. It consistently underperformed its benchmark in the early days – not that anyone noticed….
The message here is clear. Don’t be led into believing that passing barriers like a previous high are important in themselves. And always remember that index trackers need as much careful research as any other type of fund.
Brian Tora is an associate with investment managers, JM Finn & Co