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Brian Tora: The problem with indices

Indices both at home and overseas can be notoriously misleading.

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It was a long time coming but at last we made it. The FTSE 100 index finally topped the level attained more than 15 years ago – just – and not for long, either. Still, it is nice to think we have managed to play a little catch up on the domestic front, even if it feels something of a pyrrhic victory. After all, to take account of the inflationary impact that the period since December 1999 has delivered, the index would have had to have risen a further 30 per cent.

Even low inflation erodes value over time. Some financial assets should be a means of compensating for the rise in the cost of living, most notably ordinary shares, which are able to benefit from rising profits, dividends and asset values over the longer term. So why have equities proved such a poor place to have left savings over the past 15 years, based on the performance of our benchmark index?

Indices can be notoriously misleading. The Dow Jones Industrial Average (still the most quoted guide as to how Wall Street is behaving) is share price – rather than market capitalisation – weighted and contains only a limited number of companies that may not even be the biggest in the market.

Our own FTSE 100 contains companies that choose to list in London for prestige purposes but conduct their business outside of the UK, which means it does not reflect the fortunes of the domestic economy. The FTSE 250, the next rung down the ladder, is a far better bellwether for how UK plc is shaping up. That hit new highs years ago.

Moreover, the FTSE 100 has been distorted by the dominance of certain sectors over time. Before the financial crisis of 2007/08 by far the biggest influence on index performance was bank shares. The implosion of value that took place in the wake of this upset helped the index halve and brought to an end a period of constantly rising dividends.

The financial sector was swiftly replaced by resource stocks as the key driver of index performance. But a slowdown in growth in China and the fall in demand for both oil and metals saw the share prices of these commodities Leviathans tumble, which acted as a brake on the index. Little wonder making money out of the FTSE has been so tough.

Yet I read increasingly of bubbles developing in major markets. True, America’s Nasdaq exchange has returned to technology bubble levels but that was 15 years ago too. The problem seems to be twofold. On the one hand, nobody really knows what the correct valuation level for a market should be. On the other, many market commentators are nervous over the effects of withdrawing the monetary stimulus on financial markets – myself included.

We are likely to discover what, if any, consequences can be attributed to monetary tightening sooner rather than later. While Janet Yellen on her latest testimony to Congress did not set out a timetable, it was clear the next move in interest rates was likely to be up. Perhaps the biggest unknown is how the Fed – and other central banks come to that – is going to deal with its massively larger balance sheets. We are likely to have a steep learning curve over the next year or so.

Which leads me to give just a quiet two cheers for the FTSE rescaling the heights attained at the end of the last millennium. In the quarter century or so I have been sharing my thoughts on investment with the readers of this august journal, I have taken many opportunities to extol the virtues of active management and to warn of the attendant risks of index matching. This latest milestone simply reinforces my views on this matter.

Brian Tora is an associate with investment managers, JM Finn & Co.

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