ISAs and Investment Funds

Published on:

March 18, 2010

5. Introducing The Index Tracker

An index tracker is essentially a cheap, simple investment fund that mimics the performance of the stock market. But, in order to understand how they work, it's useful to know a little bit about stock market indices.

An index is a method of tracking how well a stock market, or a particular sector of it, is performing. It enables investors to assess how well they are doing, by comparing their own performance against it. They can see if they are outperforming (doing better than the index) or underperforming (doing worse). Each index is made up of many different companies. The level of the index is calculated by taking an average of all its constituent companies' share prices.

When you hear on the news that the "Footsie has risen 50 points today", this refers to one of the most widely used stock market indices in the UK, the FTSE 100.

But what does a rise of 50 points actually mean? Say the index rises by 50 points from 5,000 to 5,050, or 1%. This means that the value that the stock market is placing on all of the companies within the FTSE 100 has gone up by 1%. The price of each company is determined by the buying and selling of its shares on that day, whether it is done by big firms in the City or retail investors like our good selves.

In the case of the FTSE 100, and indeed most indices, the calculations are made by weighting each company's share price according to its market value. So the share price movement of a company worth £100bn is ten times more significant that the movement of one valued at a mere £10bn.

One key point to be aware of, though, is that most indices only track movements in share prices. A significant portion of total stock market returns come from dividends. So if you are comparing your portfolio's performance against an index, you'll need to exclude any dividends you've received. Alternatively you can measure your performance against a Total Return Index, which is an index that includes both share price movements and dividends. Data for such indices can be quite hard to track down however.

Different types of index

There are literally hundreds of different indices across the globe. As well as tracking the markets of whole countries you can also get indices that track individual industries or large geographical regions like Europe or the Far East.

In the UK the main indices include:

  • FTSE 100 - the largest 100 companies listed in the UK.
  • FTSE 250 - the 101st to 350th largest companies (often referred to as "mid caps").
  • FTSE 350 - the 1st to 350th largest companies.
  • FTSE SmallCap - smaller listed companies that aren't in the FTSE 350.
  • FTSE All-Share - the aggregation of the FTSE 100, FTSE 250 and FTSE SmallCap Indices - around 600 listed companies in total

(Despite its name, the All-Share index doesn't include all companies listed on the main London market -- there's a FTSE Fledgling index for ones that are too small to qualify for the All-Share.)

Major US indices include the Dow Jones Industrial Average (the Dow), the S&P 500 and the Nasdaq (where most technology shares are listed). Others indices you may come across include the Nikkei (Japan), Hang Seng (Hong Kong), Dax (Germany) and CAC 40 (France).

Each index has it own rules, drawn up by the company that runs it, which specify exactly how it is calculated and when changes are made to the companies that constitute each index. For example, the FTSE 100 has a reshuffle every three months to ensure that it continues to consist of the 100 largest companies listed in London.

Index trackers

An index tracker is a fund that holds shares in the same proportion as an index. So a FTSE 100 tracker attempts to mimic the performance of the FTSE 100 and so on. When the make up of an index changes, the index tracker will adjust its holdings accordingly. So an index tracker differs from most other funds, collectively referred to as managed funds, where it's the fund manager who decides when and which companies are bought and sold.

It is often difficult for the fund to exactly mimic the changes in an index, as they may not be able to buy or sell shares at the same price as included in the index calculations. These differences cause what is known as tracking error, which is simply a measure of the difference between the performance of an index and an index tracker that follows it. In practice though, these differences tend to be very small.

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