Index investing

Index investing

what are indices?

Stock market indexes are simply a way to guage the performance of a range of stocks as a whole as opposed to reviewing the performance of evry single stock. The Dow Jones Industrial Average (DJIA) is probably the most famous index in the world, containing the 30 largest companies listed in the US. Most indices are calculated on market capitialisation (number of shares in issue x share price), hence the FTSE 100 in the UK contains the 100 companies with the largest market capitalisation in the UK. As companies fortunes change some grow or reduce in size and so from time to time the index constituents will be adjusted accordingly.

As described above an index is simply a group of shares put into an imaginary basket which can then be used as a benchmark to guage the performance of a particular stock against it's peers. You will often hear fund managers advertising their offerings as "outperforming the index", which simply translates as providing a better return than the index that they reference. Indices are a great way to quickly see the trends that the market is taking.

How to invest in indices

How to replicate index returns

There are many index funds available to investors that offer a great way to seek the returns of an index. In the UK the most basic form would be a FTSE index tracker. This is simply a fund that will buy shares in all of the 100 companies that make up the FTSE 100 index (in the right market capitalisation weighted portions) so that the funds values and returns closely reflect the index itself.

Benefits of index investing

The main benefit for the investor is that they can gain exposure to the index without having to go out and buy stocks in 100 different companies, they simply invest in the fund. In addition because the funds do not require active fund management (they simply need to maintaing the correct wieghting of holdings as the index changes) fund management fees are usually extremely low compared to more actively managed funds.

Which index?

There is no easy answer. Over the last few years many of the large investment banks and exchanges have been composing a huge number of different indexes that can now be traded in the form of funds. There are the traditional Dow Jone/FTSE style indices that have been around for years and are used as a benchmark for the overall market. In addition there are now a large number of more focussed indices that will only consist of companies related to a specific industry or sector, for example utilities, commodities, banking or telecomunications. Such industry specific indexes offer you the chance to benefit from an upward trend in a specific industry.

Too good to be true?

There are many index tracker funds that guarantee to beat the index returns. On the face of it this sounds like a great investment that you should jump at however you should remember that there is always a catch. What you must remember is that when you invest in shares (as the fund will) you receive regular dividend payments from all of the companies they invest in. The returns you will be guaranteed when investing in the fund will only be related to growth % of the index, not the growth % plus dividend payments. This is not a major downside however it is worth considering such points when and investment sounds too good to be true.