Indices huh? What can I possibly tell you about them.

This is the third post in a triumvirate (now there’s a big word) aimed at newbies who want to spread bet on shares and share indices. The first post dealt with shares and how to value them (including Market Cap, EPS, P/E and pizza) while in the second I gave a discourse about dividends (including why there’s no such thing as a free lunch and what those “credit due to dividend adjustments” entries in your account summary mean). So in this last-but-by-no-means-least post I’ll be discussing stock markets indices. Or blathering about them. Depending on your point of view. And how long this caffeine kick I’m on lasts.

Wazza index?
Since you were knee-high to a grasshopper you’ve probably heard disinterested news readers ending their radio programmes with “In financial news the FTSE closed thirty points up. Now over to Julia for the weather”. Terms like the FTSE and the Dow can become very familiar without anyone really understanding what they are. So, here goes.

An Index can be defined either by what it is or what it does. It is a “basket of stocks”, but that’s about as enlightening as a set of flat-pack furniture instructions … written in Korean. What it does is let people see how well a stock market is performing.

While seeing how a stock market is doing can be interesting in itself the reason most people watch indices is to have something to rate their fund manager’s performance against. In other words if the market rises 10% in a year and your fund manager only gets 8% then go get a big stick and beat him. Or, if the market performs 10% and your fund makes 13% then consider throwing another few million (or whatever small change you have lying around) in his direction. And if you happen to be your own fund manager I guess either some self-flagellation or else treating yourself to a great night out is in order (if the two are the same thing … let’s not go there!)

Each index contains of a number of stocks (hence the ‘basket’ analogy). Common ones are:

• FTSE 100: contains stocks of the 100 largest companies quoted on the London Stock Exchange
• FTSE 350: contains stocks of the 350 largest companies quoted on the London Stock Exchange (you might occasionally come across the FTSE 250 – which are the companies listed in the FTSE 350 but not the FTSE 100 … ie companies that are large but not large enough to make the top 100)
• ISEQ: contains stocks of the 60 or so companies listed on the Irish Stock exchange
• DAX 30: contains stocks of the 30 largest German companies
• The ‘Dow’ or, to give its proper title, the Dow Jones Industrial Average: contains stocks of the 30 largest US companies. The word ‘Industrial’ here is a red herring; the index contains stocks such as Microsoft and Walt Disney which have zilch to do with ‘heavy industry’
  Standard & Poors 500: contains stocks of the 500 largest US companies
• Nasdaq 100: contains stocks of the 100 largest companies on the Nasdaq Stock Exchange. Nasdaq has generally attracted technology stocks so the index has become a proxy for technology companies

Some Vaguely Interesting History Stuff
It feels like the FTSE 100 has been with us since forever. However it only started life in 1984 with a value of 1000. The FTSE 100 is just a wee bairn compared to the grand daddy of all indices, the Dow Jones Industrial Average. That venerable old-timer was started by the then editor of the Wall Street Journal, Charles Dow, way back in 1896. He used it to help him develop his nascent ideas on Technical Analysis. So if you ever get a Trivial Pursuits question on indices, now you know.

The Fall And Rise Of … An Index
The amount an index rises or falls each day depends on what has happened to its constituent stocks. So for example if an index has an opening value of 100 and during that day the constituents have “on average” gone up 2% then the index value at that day’s close of play will be 102.

Just a little subnote: every number needs a unit. So share price changes are measured in cents or pennies and currency changes are measured in cents or ‘pips’. And indices are measured in ‘points’. Hence the “FTSE rose thirty points” yesterday.

When Is An Average Not An Average
So far I’ve made the maths of indices sound quite simple – and indeed it is. However every index uses its own flavour of ‘simple’. For example the Dow uses a “price weighed” average. So the value of the Dow is based on adding up the price of each of it’s constituent stocks and dividing by the number of stocks in the index (if you want the full description of the maths check out the Dow Jones website’s FAQ and it’s methodology page). The effect of this is that the index becomes biased towards the stocks with the highest share prices – so a $1 rise in General Electric may be countered by a $1 fall in Du Pont, despite the fact that General Electric is almost 10 times larger than Du Pont.

The large majority of indices, including the FTSE, the ISEQ, the S&P 500 and the Nasdaq 100, get around this problem by using a ‘market cap weighted average’ calculation. Now I can explain that in two ways – using maths or not using maths.

Here’s the non maths explanation: ‘market cap weighted average’ indices are set up so that the change in the price of a company with large market cap (e.g. Vodafone) will have a greater impact than that of a smaller company (e.g. Thomas Cook). Which kinda makes sense – after all more people have invested more money in Vodafone than in Thomas Cook (hence Vodafone having the larger market cap. So Vodafone can be thought of as a more important player.

For the good-with-figures types (and you’ll notice I’ve avoided the obvious sexual innuendo jokes here) the way it works is you add up the market cap for every stock in the index. That gives you the ‘index market cap’. Then divide each constituent company’s market cap by the index market cap and you get the weighting for those companies.

So let’s say Vodafone has a market cap of £100bn and the FTSE has a market cap of £1,500 bn. In that case Vodafone has a weighting of 100/1500 * 100 = 6.6% of the FTSE. And if you are wondering why you should care about this … read on!

Lesson 1 – Know What’s In Your Basket
When trading an index it’s always worth knowing what that index consists of. Now in practical terms it is hard to keep track of all 100 stocks in the index – however you should keep your eye on
a) the largest stocks with the largest weighting and
b) the sectors that are most heavily represented.

The ISEQ, for example, fell 19% in 2007 and was one of the poorest performing indices in the world - only Venezuela did worse. Run a finger (an index finger … geddit?) down the list of constituents and you’ll soon see why. The top 5 Irish companies are CRH – a cement manufacturer – and four retail banks. You couldn’t have got a better exposure to a falling housing market and credit crunch issues if you tried.

Lesson 2 – Watch The Reshuffles
Most indices have a fairly strict set of rules that decide which stocks should – and should not – be constituents. The publishers of the index hold reviews every so often and if a company no longer matches the criteria it is replaced.

The FTSE 100, for example, only holds the 100 or so largest companies listed on the London Stock Exchange, with market cap being used as a proxy for size. So if a share price collapses, as was the case with Northern Rock, then the market cap declines and the share needs to be replaced with a larger one.

The FTSE 100 and 350 indices are reviewed and changed every quarter, in March, June, September and December. As many fund managers track the FTSE 100 they will need to buy the new shares entering that index. But money doesn’t grow on trees so to generate the cash to buy those shares they’ll have to sell something. And guess what’ll be top of the list to be sold? Yep … the shares that are no longer part of the index.

Summarising all that into one sentence: a stock exiting the FTSE is going to drop in price and a stock entering it is going to rise. In the short term at least.

Unlike the FTSE, which has a strict set of mathematical criteria for inclusion, the Dow and the S&P 500 are reviewed by committees and changed whenever the respective committee feels it is necessary. Changes to the Dow, in particular, are few and far between – however the first one in nearly four years happened a few days ago and it had a big impact on certain stocks.

Lesson 3 – Dividends Count For Spread Bets Too
Let me say two things at the start of this section. Firstly this bit is really about accounting - in reality it’s going to make little or no difference to your wealth. So if you want to skip on to Lesson 4 be my guest. However if you are the ‘nuts-and-bolts’ type read on …

Secondly this bit is going to make absolutely no sense unless you’ve know how spread betting companies handle dividends. So take a few minutes to remind yourself with the relevant bit of the last post in this series.

Right, now that’s done you’ll remember that you either receive or have to pay dividends for rolling daily bets share prices if you have a position open. Well an index is just a basket of stocks. So if a FTSE 100 stock, for example, is paying a dividend and you have a long position on the FTSE Rolling Daily you’ll see a small payment into your account. Equally if you have a short position again you’ll see a small payment leave your account.

The size of the payment is determined by the weighting of the stock in the index. So you’ll see a bigger figure from a Vodafone dividend than a Thomas Cook one. Both are pretty small though.

Two more things to carry forward from this bit of the last post. Firstly don’t forget the 90% long, 100% short thing I talked about post holds true for indices too. So if you have a long index position you’ll be receiving 90% the dividend and if you have a short position you’ll have 100% of the payment deducted from your account.

Also although there will be a cash adjustment in your account, in reality it makes no difference to your wealth. This is because, just like a share price falls when it pays a dividend, so an index price also falls when the stocks it contains goes ex-div.

So what you end up with on an ex-div date is:
- if you are long you receive a dividend – but you lose a bit as the price of the index falls.
- if you are short you pad a dividend – but you gain a bit as the price of the index falls.
As I said at the beginning, the end result is little or no difference to your wealth. And if you aren’t the nuts-and-bolts type I bet you wish you’d taken my advice and skipped this section!

Lesson 4 – Don’t Forget That An Index Is Just Stocks
The final point in this list is so simple it might sound dumb – and yet it is such a common mistake. Time and again people forget that the FTSE and the Dow are not instruments in themselves. So when the index rises or falls people look for macro-economic reasons rather than looking at the news flow for particular companies or sectors.

A useful tool to understand a bit more about what is moving a market is a heat map. It shows which sectors that are having the most impact on an index price. Digital Look have a free one, although you have to register. Also take note: it shows movement across all stocks, not just those in a particular index. If you know of another one feel free to stick the URL in the comments box below.

And To Summarise…
I’m sure blogs are meant to be short, sharp and to the point. But not mine – oh no – mine are beasts. And I’ve covered so much stuff here that I’m going to end with a summary.

• Indices are a ‘basket of stocks’. They rise or fall depending on what happens to their constituent stocks.
• Most indices use a ‘market cap weighted average’ calculation, so they are more heavily affected by large stocks than by small ones. However a few, including the Dow Jones 30, don’t use this method.
• It pays to know what stocks and/or sectors are heavily represented in your index.
• If you trade rolling daily indices you’ll see some dividend adjustment payments either entering or leaving your account. However these will probably make little or no difference to your wealth as they’ll be offset by changes to the index price.
• If you are trying to understand why an index is moving up or down have a look at which of the underlying stocks / sectors are moving the most.

That’s it for now. May the markets be with you.