Stock market indices such as the FTSE 100 of leading UK company shares, or the S&P 500 in the US, are a vital component of the investing landscape.
They act as financial barometers that reflect the changing fortunes of a specific collection of stocks and shares, bonds, or other securities.
As well as providing investors with an indication of how a market is performing, indices also form the backbone of retail investment vehicles called index tracker funds.
Here’s how these funds work and what would-be investors need to know about stock market indices in general.
Note that investing is not suitable for everyone. It is speculative and your capital is at risk, meaning you could lose some, or all, of your money.
What is a stock market index?
A stock market index provides a standardised way of tracking changes in the price of a basket of securities.
‘Securities’ is an all-encompassing term that includes stocks and shares (or ‘equities’), bonds and commodities such as precious metals, oil and agricultural products, including animal livestock, cotton and wheat.
Indices enable investors to see how a market performs day-to-day and year-to-year. They also help investors to gauge how the performance of different markets worldwide compare with one another.
How does a stock market index work?
Most stock indices, such as the FTSE 100, are weighted by the size – or stock market capitalisation (market cap) – of the individual constituent companies or securities in question. A company with a market cap of £20 billion would therefore have double the weighting within an index of a company worth £10 billion.
A market cap is worked out by multiplying the current share price of a company by the total number of shares in issue.
Once each company within an index has been weighted, the combined market cap of all the shares is calculated on a daily basis. This gives an overall value of the index, allowing investors to see how its performance alters over time.
Why are stock indices useful?
Indices provide a snapshot of the performance of a market without the need to analyse the performance of the individual companies within it.
They are also an important tool for assessing the performance of investments.
For example, ‘actively managed’ funds – those that call on the skills of a fund manager to choose between different companies for inclusion within a portfolio – are often measured by their ability to beat a stated ‘benchmark’ by a prescribed amount.
In many cases, the benchmark is a stock market index. If the target for a particular fund is a percentage point above the FTSE 100, the manager is therefore trying to achieve the same level of return as the index plus 1%.
Indices are also central to the working of so-called ‘passively-managed’ funds.
What is passive investing?
The ‘passive’ method of investing provides access to a wide variety of securities, often at a lower cost compared with the active funds mentioned above.
With passive investing, the aim is to copy, or track, the return achieved by a particular stock market index (or other benchmark) using computers to maintain a stock portfolio that shadows the target index in question.
For example, this could mean replicating the performance of the FTSE 100, S&P 500, or any of several thousand other stock indices.
The growth to passives in recent years is not surprising given that only a minority of active managers are able consistently to produce a winning performance record over time. According to S&P Global, over the past 15 years, nearly 90% of actively managed funds have underperformed their benchmarks.
And recent research from investing platform AJ Bell shows that this year has been an “annus horribilis” for active UK equity funds. It says that only 27% of active funds have been able to beat passive alternatives in 2022, down from nearly a third of funds who managed this feat in 2021.
Given the inability of the majority of active funds to underperform their benchmarks, US investing legend Warren Buffett has described index trackers as making “the most sense practically all of the time”.
Retail investors rely on two main products to invest passively: index trackers, and exchange-traded funds or ETFs. Find out more about ETFs here.
How do index trackers work?
Index tracking funds are ‘collective’ investments. This means the money comes from pooling the contributions of thousands of investors into one pot.
When investors put their money into an index tracker, the cash is used to invest in all the companies that make up a particular index. This provides investors with a more diverse portfolio compared with buying, say, just a concentrated handful of stocks. Diversification is useful for investors as it helps to reduce risk.
Some index trackers buy all the stocks in a particular index, a process known as ‘full replication’. Other index fund providers use a technique called ‘optimised sampling’ to create the profile of an index without necessarily buying and owning all of the underlying stocks contained within it.
One way of weighing up the performance of an index fund is to consider its tracking error. This reflects how much an index fund’s performance deviates from the index or other benchmark it’s meant to be tracking.
Tracking error is measured as a percentage, so a tracking error of 0% indicates perfect replication.
Most index trackers are set up as ‘open-ended investment companies’, or OEICs. Others are structured as unit trusts. The common feature to both types of fund is that they are ‘open-ended’ in nature, which means there’s a potentially limitless supply of shares – or units – available in each.
Investors in tracker funds can only (at best) expect to mimic the performance of a particular index. It’s also important for investors to remember that, in tracking the fortunes of a particular index, their investments are both liable to fall as well as rise over time.
What’s the best way to invest in index trackers?
Investors can buy index tracker funds in a number of ways. It’s possible, for example, to buy direct from a fund manager provider. But the most popular ways for retail investors to purchase holdings are via an online investing platform or mobile trading app, or through a financial advisor or semi-automated robo-advisor.
To invest in index funds tax-efficiently, investors should consider doing so via an individual savings account (ISA). If desired, up to £20,000 each year can be invested in index funds via a stocks and shares ISA where holdings are sheltered from both dividend tax and capital gains tax.
How much do index tracking funds cost?
Not all tracker funds are the same. Some are cheaper than others, while some are better at accurately replicating the performance of an index. Overall, however, passive investments tend to be cheaper than their actively managed counterparts.
Regardless of whether it relies on full or partial replication, an index tracker – underpinned by computing power – tends to cost less to run than it would if it employed a team of active managers and their support staff. Investors still need to pay an annual fee, however, to cover an index tracker fund’s costs.
The average annual management fee for a tracker fund stands in the region of 0.05% to 0.2%, compared with 0.5% and 1% for an actively managed fund.
Using the higher of each pair of figures, this means that a £1,000 investment in a tracker would typically cost £2, compared with £10 for an active fund.
Investors may also have to pay a transaction fee on buying or selling a tracker fund, in addition to an annual platform fee for holding the fund if the purchase is made via an online service provider. It’s worth investors comparing the best trading platforms for their individual circumstances as fees can vary significantly between providers.
Tracker funds can also be bought within a tax-efficient wrapper such as an individual savings account (ISA). Investments held in these products are free from capital gains and income tax.
Whichever the route, charges eat into an investment’s capacity to make money. So, it’s essential for investors to pick a service that’s most cost-effective to their personal investing needs as well as matching any other requirements – appropriate choice of funds, for example.
What’s the risk of investing in index trackers?
Any kind of stock market-based investing involves risk. An index fund that owns dozens, if not hundreds or even thousands of shares, is better diversified than a portfolio that holds just a handful of securities.
In the example of a stock index fund, each company would have to fail before investors lost everything. That said, depending on its focus, an index fund could underperform and lose money for several years if, say, a sector or investment region fell out of favour.
