Rather like cricket scores and the weather forecast, we get used to hearing about stock markets on a regular basis without paying a lot of attention. In fact they are big businesses in their own right. The first demonstration of that was the 2012 acquisition by the London Stock Exchange of Pearson’s 50% stake in FTSE, the index provider, for £450m. Since then the LSE has gone on to acquire the Frank Russell Company, a US Index business, for £1.6 billion. Clearly, keeping the scores for investors must be lucrative to attract so much capital to the seemingly mundane business of totting up share prices at the end of the day.
One reason for the increased interest in index businesses is the steady rise in passive investing which currently accounts for a little over 10% of total industry funds under management, having risen from virtually nothing over the last few decades. A passive fund needs a clearly defined index to use as a reference, both for construction and for benchmarking. It is only 30 years since the modern FTSE indices were first constructed and even the S & P 500 only dates back to 1957. Before that a group of wise men determined the constituents of the FT30 and a similar process still happens in the USA for the respected Dow Jones Index.
Modern fund management demanded something a lot more tangible which gave index providers a great business opportunity. It was then recognised that passive fund managers, and active ones as well, needed to know exactly which stocks were in the index, which might be joining or leaving and what is the weighting of each stock should be in specific indices.
To keep things simple index providers used the most basic measure of each company, its market capitalisation, to determine the overall size of the index and the weight of each stock within it. Market capitalisation is easily calculated by multiplying the share price by the number of shares in issue. It therefore tends to inflate the value of companies that are popular and has no connection with the underlying financial attributes of the company such as earnings, dividends or debt. Theorists say that the ruthless efficiency of capital markets will soon rumble those companies that are mispriced.
Unfortunately that theory was blown up first by the dot…
As a rules based investor, this is an interesting subject. Index-funds are essentially a form of rules-based investing where the aim is not to beat the market, but supposedly to get the market return.
However, index funds can be subject to market manipulation. Market makers have been known to bid up the share price of companies hovering below an index threshold knowing that once they become part of index they will automatically go on the buy-lists of index funds. Thus, with index funds you may not be buying into an objective list of stocks.
This is just one of the reasons I am not very convinced of the merits of index funds. Another is that by buying into an index fund weighted by market cap, the fund will tend to "buy high" and "sell low" as it re-balances over time.
The idea of an index based on something other than market cap in principle sounds like a great idea. Certainly, it would make any index difficult to manipulate. However, it would also have the effect of skewing markets towards that particular metric. I am guessing that if an index based on dividend payouts were widely adopted would tend to increase the share price of high dividend shares and weigh heavily on growth stocks like ARM and Shire that and might push such stocks out of the FTSE100 all together.
Perversely, it sounds like a really good idea, as long as it doesn't take off!
