In a broad sense, indices are used to measure performance of the stock market and by extension the economy. They can also be used to construct index portfolios such as trackers, help technical analysts for charting and provide a basis for beta* calculations to measure risk.
Investors will be familiar with a variety of equity indices: the UK top 100 companies in the UK, the Dow Jones Industrial Average in the US, which dates back to 1896, are two of the most famous names.
There are three primary methods used to calculate equity indices. Price-Weighted indices, such as the Dow Jones, are calculated through a simple arithmetic average of share prices. Clearly, they can be distorted by companies with large share prices, which may not necessarily be reflective of the underlying market capitalisation. Market Value-Weighted indices, such as the S&P 500, are calculated by averaging the total value of each component in the index. These indices are biased towards those stocks with higher market capitalisations. In the UK top 100 companies, two stocks, BP and Shell, provide over 10% of the total index. The top 20 stocks in the S&P 500, 4% of the total, represent nearly 30% of the index. In an Unweighted index, including the FT 30, the oldest UK index which dates back to 1935, all shares contribute equally, regardless of price or value. As constituents may be acquired or delist, indices need to be rebalanced periodically to keep them meaningful. Given the inherent biases, we believe that equity indices are always going to be imperfect, although they represent a useful point of reference. Bond indices are more challenging to calculate because the market is larger and constantly evolving with new issues and maturities. Indices cover investment grade**, high yield and global bonds from sovereign and corporate issuers.
Private clients are likely to be familiar with the WMA Private Investor Indices. The WMA provides five indices designed as indicative benchmarks for portfolios of differing levels of risk: the Conservative, Income, Balanced, Growth and Global Growth. They are calculated by combining a number of underlying indices in varying proportions across equities, bonds, property, cash and alternatives. Weightings are reviewed quarterly by the WMA Indices Advisory Committee with changes made to recommended allocations on a less frequent basis guided in part by how member firms, including WHIreland, are managing portfolios.
It is debatable whether the WMA indices are entirely appropriate. The indices are in large part theoretical. For example, all bond exposure is represented by the UK Gilts All Stocks Index, perhaps in reflection of the difficulties in finding an appropriate benchmark for bonds. In practice, however, most investors will hold significant exposure to corporate bonds for the income yield, although they will have a different return profile to gilts. Additionally, the alternatives weighting is difficult to benchmark against as investors are likely to hold a variety of different assets in this area
Passive investing involves close adherence to a benchmark often through investing in index funds. In a situation where the index is led higher by a small number of large capitalised stocks, a passive investor is likely to have an advantage over an individual stock picker. This has certainly been the case so far this year in the UK top 100 companies with oil stocks performing strongly and the S&P 500 pushed higher by technology stocks. However, the downside of passive investing is that investors are forced into buying overvalued stocks or areas of the market which may underperform in the long run. In any case, when comparing performance against an index it is essential to consider it in the light of the relative risk of the portfolio as measured by beta*. Ultimately long-term returns will depend on market timing as much as any other factor.
In March 2017, the WMA indices will be changing to a new partnership with MSCI instead of FTSE. Further information will be available closer to the time about the composition of the new indices. We believe they are likely to be more representative of what investors’ portfolios actually look like in practice.
It is a fact that successful investors have shown time and again it is possible to outperform their benchmark, often by taking less risk and with an unconstrained approach that avoids strict adherence to any index. We believe that a disciplined investment process can lead to superior returns over the course of the cycle but that is a process that must be measured in years not months.
*Beta: A measure of volatility of an investment in comparison to the market as a whole.
**Investment grade: a credit rating given to a stock which carries a low level of risk.