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Brian Tora: Understanding the indices

US equity indices set new all-time highs last week and the UK indices are also doing well but it is important to properly understand how an index is constructed to know what it is telling us.

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Last week saw the Dow Jones Industrial Average move into new high ground. The S&P 500 also broke its previous peak. Most encouraging – not that these two indices always produce the same results. One has just 30 companies included and is not market capitalisation weighted. The other has a far larger constituent group, with the calculation of performance allowing for the relative importance of the companies that go to make up this benchmark.

Understanding indices and how they operate has become much more important in a market where passive solutions are gaining ground over active managers. Indices can be surprisingly unpredictable. Back at the end of the old millennium, when the technology boom was at its height, shares were dropping in and out of the FTSE 100 index at an alarming rate, making tracking this benchmark something of a nightmare.

And some specific indices, like the Footsie, can be subject to some wild swings on sentiment. Up to 2007 banks were the largest sector in this index. The credit crunch put paid to that. Today it is resource stocks – mining and oil – that dominate, despite some disappointing performances from the miners in particular during the economic slowdown.

Moreover, banks and BP passing their dividends put paid to the uninterrupted rise in income this index had enjoyed since inception, though upward momentum has since revived.

Next week we will see the quarterly review of the Footsie. This index is often described as the measure of how Britain’s 100 largest companies are moving in price, but this is a little misleading. For a start, it is 100 of the top 110 companies that are included. Only if a business is ranked 90 or above in market capitalisation terms is it automatically in the index. Companies that fall to 111 or below will be dropped, but between 91 and 110 it is at the discretion of the committee that determines its composition.

Presently Royal Mail is poised to enter. Vedanta seems set to be relegated to make way. This company is a true resource stock, with its business divided between copper mining and oil. And here is where describing the FTSE 100 Share index as the measure of Britain’s top companies’ share performance also fails. Vedanta may be listed in the UK, but its business is predominantly overseas. Indeed, it is estimated that more than 70 per cent of the profits earned by Footsie companies arise outside the UK.

The one advantage index trackers should have is cost. With the charges levied by fund management groups coming under increasing scrutiny, cheaper options, like passive funds, could well see their popularity increase. But to pick a tracker without due diligence and developing a proper understanding of how it operates is just as dangerous as not researching an active manager thoroughly.

Meanwhile, we seem to be in the middle of the conference season, so far as I am concerned. Last week saw me addressing private investors in East Anglia and IFAs in the West Midlands. Passive versus active was on the agenda for the IFAs, while how to avoid tax seemed the main priority of the private punters. A fellow speaker at the East Anglian event described tax planning as more art than science and pointed to the moral dimension that had crept in.

But both audiences seemed more relaxed and comfortable with markets that seemed to have put the upsets of recent years behind them. We are close enough to 2014 to start to speculate on what the year ahead might have in store. Could we see the Footsie break into new high ground? My technical analysis friends think it will. The trouble is that I do not trust indices sufficiently to deliver.

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

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