If you have ever wondered about what purpose stock market indices serve, how they work or just wanted to know how they relate to investing, we have the answers.

Over the coming weeks we will cover all the main global indices, starting with the most recognised UK market benchmarks. We will discuss what moves them and how you can gain exposure to their performance.

FTSE 100 INDEX

You should have heard of the FTSE 100 index in articles about the stock market but in reality only a few of the biggest companies ‘move’ this benchmark.

The FTSE 100 index encompasses the largest 100 publicly quoted companies on the UK market. Each constituent is weighted by market capitalisation (number of shares in issue multiplied by the share price) which means that giant behemoths like Royal Dutch Shell (RDSB) are far more important than retailer Morrison (MRW) which is a much smaller company.

When you see that the FTSE 100 has moved by 1% on any given day, for example, it’s generally the result of share price movements in only a handful of sectors including oil companies, miners or financial stocks.

The FTSE 100 is dominated by oil and gas (18.7%), financials (18.6%) and and consumer goods which represent 17.1%. 

HSBC (HSBC) is the largest financial at 6.1% of the FTSE 100. In consumer goods, British American Tobacco (BATS), Diageo (DGE) and Unilever (ULVR) cumulatively make up about two thirds of the sector and 10.7% of the FTSE 100.

The oil and gas sector strangely includes Glencore (GLEN) which is best known as a miner and commodities trader.

With just eight stocks, you can get exposure to 41% of the FTSE 100: Royal Dutch Shell, BP (BP.A), HSBC, British American Tobacco, Diageo, Unilever, AstraZeneca (AZN) and GlaxoSmithKline (GSK).

Share prices in miners such as Rio Tinto, BHP (BHP) and Anglo American (AAL) tend to be more volatile.

All these businesses earn most of their earnings from outside the UK but their share prices are in pounds. Therefore foreign exchange rates versus the pound really matter to the FTSE 100.

THE ROLE OF INDICES IN INVESTING

Indices are used to help benchmark fund managers’ performance as well as for investors to passively track certain parts of the market.

Crucial to effective measurement of performance is comparing fund managers on a like-for-like basis. It’s no good comparing a manager that only invests in micro cap companies with a manager who invests in large cap companies. It simply won’t inform you about relative investment skill.

Over the years various companies have developed benchmarks designed to make performance measurement more effective. As such, benchmarking has become a hugely competitive business. For example, the London Stock Exchange (LSE) owns the FTSE Russell indices and provides analysis and real-time data to fund groups.

The huge growth in passive investing over the last 10 years has led to a proliferation of products that track indices and allow investors to gain exposure to large parts of the market at very low cost.

For investors just starting out as well as those with more experience, exchange-traded funds (ETFs) and tracker funds can provide a diversified portfolio with exposure to large swaths of the stock market.

PROMOTION AND RELEGATION EACH QUARTER

The composition of the index changes according to the performance of the shares in the index. At the end of every quarter, the smallest companies in the index get relegated to the mid cap FTSE 250 while the largest companies from that index get promoted to the larger FTSE 100 index.

Over the last five and 10 years the index has delivered a cumulative return of 9.9% and 41.6% respectively. It should be noted that the return excludes dividend income.

One way of getting passive exposure to the index is via the iShares Core FTSE 100 ETF (ISF). It mirrors the performance of the FTSE 100.

FTSE 250 INDEX

The FTSE 250 index is often called the mid cap index because its members are smaller than the giants in the FTSE 100, but still decent size companies, with the top five having an average market cap of around £5bn each. It represents the next 250 largest quoted companies on the UK stock market after the FTSE 100.

One of the differences compared with the FTSE 100 is that there is a smaller gap between the largest members and the smallest, so the FTSE 250 index is a better reflection of the performance of all its members.

That said, it is dominated by some large sector weights such as financials which represent 42.4% of the index, while industrial stocks are 19.6% and consumer services 14.2%. Altogether these three sectors are 76.2% of the index.

The FTSE 250 index is more domestically focused than the FTSE 100 and therefore better represents the domestic economy.

The total size of the FTSE 250 is £456bn, which is around a fifth the size of the £2trn FTSE 100.

The FTSE 250 is a favourite hunting ground for fund managers looking for an edge because there is less analyst coverage of the companies in the mid cap part of the market and, it is thought, more room to find mispriced stocks.

Over the last five and 10 years the index has performed much better than the FTSE 100, delivering cumulative returns of 30.9% and 131% respectively.

One way to get passive exposure to the index is through the Vanguard FTSE 250 ETF (VMID).

Disclaimer: Editor Daniel Coatsworth owns shares in Vanguard FTSE 250 ETF.

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