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While looking into the exact composition of a financial market index may seem no more relevant to some investors than a debate over how many angels you can fit on the head of a pin, the make-up of key benchmarks can be a vital contributor to portfolio returns. This issue is only likely to become more acute at a time when more and more of us are flocking toward low-cost tracker and exchange-traded funds (ETFs).
A tracker or ETF will simply look to mirror the return provided by a given index, net of any fees and transactional costs, so the headline number from a benchmark is terribly important. And it is easy to show how differences can and do arise.
- In the UK, the FTSE 100 is down by 2.7% in 2015 to date. By contrast, the FTSE 250, the FTSE Small Cap and even the FTSE AIM All-Share are up by between 6% and 8%.
Mid-and small caps have so far outperformed the FTSE 100 in 2015
Source: Thomson Reuters Datastream, AJ Bell Research
- In the USA, the 30-stock Dow Jones Industrials is up by 2.2% so far this year but it is lagging badly behind the S&P 500 of 4.8% and also the NASDAQ Composite, which has more than 3,000 constituents.
The Dow Jones has lagged other indices in the USA in 2015
Source: Thomson Reuters Datastream, AJ Bell Research
- In Japan, the Nikkei-225 is up by 14.8% so far in 2015, just less than the broader Topix and just more than the relatively new JPX-Nikkei 400 by 14.4%, in local currency terms.
The gap between the leading Japanese indices is less marked
Source: Thomson Reuters Datastream, AJ Bell Research
These variations can be attributed to three factors, all of which must be considered carefully by investors when it comes to building a portfolio, especially if they prefer to use passive funds like trackers and ETFs to build their exposures. They are
- Country
- Constituents
- Method of calculation
The first two will be a matter of taste and strategy. The third may seem a less relevant point but it is not – just consider that over the last year, the FTSE 100 is down by 5.7% yet the average stock is up by 5.8%. This is because the index is weighted by market cap and the bigger names – banks and oils in particular have done poorly. The equal-weighted price average generates a quite different result, a situation which an active fund is paid to exploit through good stock-picking.
Country comforts
Picking the right country would have clearly made a difference to an investor’s portfolio this year. Japan has easily done the best, even allowing for the yen’s decline against the dollar.
At a time when talk of currency wars is bubbling up again, foreign exchange movements is one issue to ponder when it comes to asset allocation, although fathoming the foreign exchange markets is the devil’s work and the chances of calling it right all the time are slim to zero. A currency-hedged active or passive fund can remove this variable from the equation (albeit in exchange for a higher fee) and leave investors free to focus on economic growth, corporate profit momentum, managements’ attitude toward shareholders, local politics, central bank monetary policy and valuation when choosing a country in which to invest.
Index constituents
But picking the right index would have helped eke out a few welcome extra points of performance too, something investors could consider, particularly when it comes to choosing a tracker or ETF, if that is their preferred way to market. As this column has noted before the FTSE 100 is heavily weighted towards banks, insurers, miners and oils.
FTSE 100 mix by market capitalisation
Source: Thomson Reuters Datastream, AJ Bell Research
FTSE 100 mix by consensus profit forecast for 2015
Source: Thomson Reuters Datastream, AJ Bell Research, Digital Look, Consensus Estimates
The former two are relatively mature industries and feeling greater regulatory heat. The latter two are under the cosh from falling commodity prices in a low-growth, low-inflation world. Regular readers will recognise this chart, which shows how banks, miners, insurers and oils rank in terms of performance among the 39 sectors which comprise the FTSE All-Share. It makes for fairly ugly viewing.
How banks, insurers, miners and oils have ranked in 2015
Source: Thomson Reuters Datastream, AJ Bell Research
As such, the FTSE 100’s mix is a fairly unappetising one in the current environment. For the index to surge higher, it will need improved operational and share price performance from these four sectors in particular. Chancellor of the Exchequer George Osborne seems willing to do his bit to help the financials, adjusting the bank levy and forcing through a change of leadership at the Financial Conduct Authority, but the miners and oils need to see commodity prices recover from their current 13-year lows, as benchmarked by the Bloomberg Commodity Index.
When set against the more domestically-biased FTSE 250, let alone the S&P 500 where Apple, Google and Facebook all feature in the list of top ten stocks by market cap.
Share price performance over the past year of the 10 largest stocks in the S&P 500
Source: Thomson Reuters Datastream
Maths lesson
This is not to say exposure to technology heavyweights will always be a good thing and besides country and constituents there is a third factor for investors to assess when it comes to picking an index – and that is method of calculation.
- In the UK, the FTSE 100 is a market-cap weighted index, based on the available free float, so the larger names will exert greater influence. As already noted, the benchmark is down by 5.7% in the last 12 months even if the average FTSE 100 member is up by 5.8%. This can be explained by looking at the performance of its 10-largest constituents:
Share price performance over the past year of the 10 largest stocks in the FTSE 100
Source: Thomson Reuters Datastream
- In the USA, the S&P 500 is also market-cap weighted but the Dow is share price weighted. This means a $1 increase in a lower-priced stock can be negated by a $1 decrease in a much higher-priced stock, even though the lower-priced stock experienced a larger percentage change. As such many view the Dow as a dissatisfactory guide. For the record, the five largest share prices – and thus most influential stocks – in the Dow Jones are those of Goldman Sachs, IBM, 3M, Boeing and United Health. General Electric, the fifth biggest stock by market cap, has the least influence while Goldman, the fifth smallest, currently has the most.
Index weightings in the Dow Jones Industrials
Source: www.indexarb.com
- In Japan, the Nikkei 225 is price weighted (like the Dow Jones in America). The Nikkei 400 is market cap-weighted and features companies specially selected for their return on equity, corporate governance and shareholder relations as well as their market cap. The biggest weighting any firm can have in the Nikkei 400 is just 1.5%. The Topix is based on free-float market cap and the number of shares freely available for trading.
Safety in numbers
While the FTSE 100 has done worse than the average share price of its members over the last 12 months, the S&P 500 has done better. On a one-year view the S&P 500 is up by 4.8% while the average member is up 3.4% and to date in 2015 those figures are 1.0% and 0.6%.
This suggests the bigger cap stocks are doing better, as they have a greater weight in the index. This may therefore speak of investors crowding toward the bigger names – which can be sign that they are seeking safety, especially near market tops. The differential is quite small for now so investors need not hit the panic button but it is a trend to note.
Extensive research on the New York Stock Exchange website reveals the number of stocks setting 52-week lows currently way exceeds those setting 52-week highs, as shown by the first chart below.
52-week lows currently way outnumber 52-week highs on the S&P 500
Source: Thomson Reuters Datastream
The next chart then shows the net highs minus lows figure, again relative to the S&P 500.
52-week lows currently way outnumber 52-week highs on the S&P 500
Source: Thomson Reuters Datastream
Oddly, the loss of momentum on a stock-by-stock basis does not really show in the index, although this column is grateful to David Stockman’s ever-interesting (if occasionally polemical) website for pointing out the S&P 500 has traded within a 7% range all year – with January 15 as the low at 1,992.67 and 21 May as the high at 2,130.82. Range and breadth do seem to be poor and this may explain why the index is struggling to progress. Equally its refusal to go down suggests is it becoming more reliant on a smaller number of stocks – which is all well and good, unless those stocks finally crack too.
This may again be nothing more than the usual summer lull but this could be a useful indicator as to the real underlying health of the US market. This column will endeavour to generate similar data for the UK in the coming weeks.
Russ Mould
AJ Bell Investment Director
Written by:
Russ Mould
Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.