Exploring indices: what they are, how they work and how to trade them
Indices are a popular entry point to stock markets for traders and investors. By understanding how they are built, what drives or hinders their performance and how to trade them effectively, indices can be an important part of a portfolio.
IN A FEW WORDS
Indices Trading indices FTSE 100 FTSE 250 Dow Jones S&P 500
4 min reading
Indices are the prism through which many of us see stock markets. They can be used to measure the performance of a variety of different asset types but the highest profile are those that measure the share prices of a group of companies, usually the largest listed in a specific region. They are a useful tool to take broad, diversified exposure to stock markets.
Most indices are market capitalisation weighted. That means the performance of the index will be more influenced by the share prices of the largest stocks. For the FTSE 100, that includes the pharmaceutical giants AstraZeneca and GlaxoSmithKline, plus firms such as Diageo, Unilever and HSBC. For the S&P 500, it is the technology groups Apple, Microsoft, Amazon, Alphabet (owner of Google) and Facebook. In Europe, the indices tend to be dominated by luxury goods groups such as LVMH Moet Hennessy and industrial behemoths such as Siemens.
That said, there has been an increasing recognition in recent years that the largest capitalisation stocks – that is those that have performed well in the past – may not be the best option for investors. At a time of increasing disruption, large companies can struggle to innovate. In some markets, it can mean high exposure to legacy industries such as oil and gas.
With this in mind, there has been an increasing proliferation of alternatively weighted indices. The S&P 500 Dividend Aristocrats, for example, is weighted to companies that have increased their dividends every year for the last 25 years. It is possible to find indices weighted to revenue growth, or volatility. More recently, there has been a notable trend towards indices weighted towards sustainability scores.
What drives an index?
By their nature, indices are a diverse collection of companies. As such, they don’t tend to be swayed by the performance of individual companies, barring some exceptional circumstances. Instead, they may be influenced by the key elements for their dominant sectors. For example, indices that are mining-heavy (the UK, South Africa) will see movement from commodities pricing, particularly the oil price. The S&P 500 will be influenced by the technology outlook: more recently, Covid-19 has been a significant influence as the world has had to rely on technology to live and work.
The largest weightings in any high profile stock index will tend to be global companies and therefore an index won’t necessarily reflect the economy in which it’s based. The revenues of Unilever or BP, for example, are not dependent on the strength of the UK economy even though they are listed there.
That said, indices can move on significant events and investor sentiment for each country. Brexit, for example, has seen the UK become something of a pariah market. International investors don’t like the uncertainty and the currency risk, even if the largest companies draw their revenues from across the globe. This has seen investment flows bleed away from the UK market and prompted significant underperformance in the UK indices relative to other markets.
In recent years, indices have proved themselves sensitive to interest rate movements and central bank announcements. If interest rates are lower, the profits and cash flow generated by companies becomes more valuable. US indices, which house lots of high growth companies, have rallied significantly as interest rates have dropped.
It is also worth noting that indices aren’t static. They will be rebalanced from time to time to reflect the changing fortunes of individual stocks. In the most recent FTSE 100 rebalancing, for example, supermarket chain Morrisons dropped into the FTSE 250, while engineering firms Renishaw and Weir Group joined the main index.
In this way, indices evolve over time. This can create trading opportunities: passive funds that track the FTSE 100 have to buy the new entrant and sell the stock dropping out of the index, which creates price movement.
There are five indices that tend to be the most widely traded: the Dow Jones measures the performance of the 30 largest blue-chip industrial companies in the US (but notably excludes may of the major technology names); the S&P 500 is the top 500 large cap companies in the US, with the largest weighting in technology names; the NASDAQ is the 100 largest tech stocks. The FTSE 100 tracks UK blue chips, while the DAX is the 30 largest stocks on the Frankfurt Stock Exchange.
Traders can get access through contracts for differences. This involves trading on leverage and betting on the price movement rather than the index itself, so it can be high risk and isn’t for everyone. For those wanting direct access to indices, exchange traded funds are usually a good option. It is possible to use short or leveraged ETFs as well.
Information or views expressed should not be taken as any kind of recommendation or forecast. All trading involves risks, losses can exceed deposits.
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