The power of passive investing is that it gives you cheap and efficient access to the market. It does this by tracking the performance of an index.
For most investors, this will make sense even on a superficial level. Well-known indices like the FTSE 100 or the S&P 500 are part of the public consciousness. There will be very few people who do not at least appreciate that they represent the UK and US stock markets respectively.
However, even a little bit of scrutiny should raise questions about how exactly an index works.
For instance, there are about 1100 companies listed on the main board of the London Stock Exchange. So why does the most popular UK index only include 100 of them? And how do those 100 stocks get chosen?
Where indices come from
The world’s first market index was published in 1884 by Dow Jones and Co’s Customer’s Afternoon Letter (which later became the Wall Street Journal), under the name Dow Jones. It was put together as a way to summarise the daily movement of stock prices on the New York Stock Exchange for readers.
That principle is what all indices since those days have tried to do – provide a simplified measurement of an entire market.
Back in 1884, investors really had no idea how well the New York stock market as a whole was doing. They could see that some share prices were up while others were down, but there was no measure of what that meant on aggregate.
This also meant that investors had no idea how well their portfolios were performing. They might be able to compare themselves against each other, but there was no standard portfolio to benchmark against.
The Dow Jones aimed to resolve both of these problems by averaging the share prices of 11 stocks – nine of them railroad companies – and tracking how this average performed from day to day.
It’s not entirely objective
Indexing has changed significantly in the last 136 years, but the basic principle is still the same: any index is an imaginary portfolio of shares, chosen to be a proxy for the market as a whole.
That implies, of course, that somebody has to do the choosing.
Back in 1884 Charles Dow just picked 11 companies that he thought were the most important to the economy at the time. His average was also literally that – he simply added up their share prices, and divided them by 11.
The FTSE 100 is somewhat more sophisticated. It is built by identifying the 100 largest companies listed in London, based on their market capitalisation. (This is the value of the entire company, which is calculated by adding up the value of all the shares in issue.)
It doesn’t just divide this by 100. It weights the companies based on their size. That means that AstraZeneca, which is currently the largest company listed in the UK, makes up around 7% of the index. The smallest companies in the index, however, each make up less than 0.2%.
Who gets in?
Since the constituents of the index are based on being the biggest listed companies in London, nobody is making subjective choices about which ones go in and out. The index is automatically updated regularly to keep it current.
However, at some point somebody did decide that there should only be 100 of them.
As Morningstar’s head of global ETF research, Ben Johnson, noted in a recent commentary:
“When you think about indexes in their original intent, which was a means of measuring markets’ performance, they’re really no different than any other form of measurement that we have at our disposal today. I think we take for granted that long, long ago, someone had to decide what an inch was, what a foot was, what a mile was. Similarly, at some point in time, someone, most notably in the case of the U.S., Charles Dow, had to decide what was going to be a good measure of the U.S. stock market.”
Measuring the market
The FTSE 100, in other words, is a measure of the market. Even though its constituents are less than 10% of all the companies listed in London by number, they make up about 80% of the market by size. That means that this ‘portfolio’ of 100 shares is a pretty good proxy for what is happening on the stock exchange as a whole.
As the largest shares are also the most liquid, this index is very easy to monitor and track. You can buy and sell the constituents quickly and easily. That is why large cap indices – like the FTSE 100 and the S&P 500 – are the most popular for index funds.
Anyone investing in an index fund is therefore investing into the same portfolio of stocks that are in the index. And this is what, effectively, gives them access to the performance of the overall market.