How to put your finger on the right stock market index

Passive investors need to be aware a country's most widely-known share index may not be representative of its wider economy. Robert Stephens investigates.

 Index

A country's most widely-known index may not be representative of its wider economy.

Gaining exposure to the performance of a specific economy may not be as straightforward as it first appears. One of the challenges in seeking to do so is an increasing level of globalisation. Many major indices are comprised of companies that generate a large proportion of their revenue from international markets, rather than from the country in which they are listed. As a result, an ETF that tracks an index in a particular country may be more dependent on the performance of the world economy than the domestic one.

This situation is commonplace among the largest indices of the world’s major economies. In many cases, they contain a relatively small number of companies that operate on a global basis. Furthermore, the way in which some major indices are constructed means that larger companies which have a significant impact on the local economy fail to have a correspondingly high status within the index.

One solution to this issue is to look beyond the best-known indices of the world’s major economies.

The UK

In the UK, for example, the FTSE 100 is often viewed as the country’s flagship index. It is usually quoted as a barometer of the performance of the wider stock market and economy by a variety of news outlets.

However, the FTSE 100’s members are internationally focused. This means that they generate around 69% of their sales in countries other than the UK. The result of this is that the index fails to accurately represent the performance of the UK economy.

In fact, it can benefit from a weaker economic outlook for the UK. For instance, weakening investor sentiment towards the UK following the EU referendum result led to a depreciation of the pound that provided a currency translation boost to FTSE 100 members that report in sterling, but which generate the majority of their revenue from abroad.

The FTSE 250, by contrast, is a far superior yardstick of the UK economy’s performance. Its members generate around 50% of their sales from within the UK, and its historic performance has more closely mirrored that of the domestic economy than the FTSE 100’s past price movements.

As the name suggests, the FTSE 250 contains 250 stocks versus the FTSE 100’s 100 members. Since the FTSE 250 is made up of smaller companies by market capitalisation than the FTSE 100, it has historically been more volatile. It also usually has a lower dividend return, but has a superior long-term track record than the FTSE 100 when it comes to capital growth.

The USA

The Dow Jones Industrial Average is a popular index to use when investors are discussing the performance of the US economy. While it provides a degree of insight in this regard, its usefulness is limited by a restriction to just 30 stocks. Since those stocks are rarely changed, they do not necessarily provide an accurate representation of the make-up of the US economy.

For example, major technology companies such as Amazon, Netflix and Facebook are not featured in the Dow Jones index despite being considered important drivers of the US economy over recent years.

Therefore, investors seeking to gain exposure to the US economy may be better served by tracking the S&P 500. As its name suggests, it is comprised of the 500 largest listed companies in the US by market capitalisation.

It adopts a different methodology to determine its price level than that used by the Dow Jones, which weights its constituents on share price rather than on market capitalisation. The result of this is that larger businesses which are likely to have a greater impact on the performance of the economy do not have a correspondingly high effect on the price level of the Dow Jones.

As such, the S&P 500 is more representative of the present-day make-up of US economy than its better-known peer. It is also significantly faster to react to changes in the importance of different sectors within the economy, which could make it more relevant than the Dow Jones in future.

Germany

While Germany has the fourth largest economy in the world, and is the dominant economy in the eurozone, its main index contains just 30 stocks. Therefore, the DAX may not be an accurate gauge of the health of the German economy.

Investors seeking to passively invest in the German economy may wish to consider the MDAX and even the SDAX. The former consists of 60 stocks that follow the 30 DAX members in terms of turnover and market capitalisation.

The latter contains 70 stocks that follow members of the MDAX based on the same criteria. As with the DAX, both indexes are updated quarterly. This means that they provide an up-to-date snapshot of the companies that are likely to have the greatest impact on the country’s economic performance.

Although the German economy is, by its very nature, highly dependent on export-led growth, having exposure to a larger and more diverse range of stocks through the MDAX and SDAX may provide investors with a more accurate representation of the performance of the domestic economy.

As with the UK’s FTSE 250, the MDAX and the SDAX may be more volatile than the DAX due to their members being smaller in size. However, in the long run they may offer greater return potential.

China

Since China’s economy is the second-largest in the world, accounting for 15% of global GDP, investing in its growth potential is likely to become increasingly popular in the long run.

The country’s largest mainland stock market is the Shanghai Stock Exchange. It has a market capitalisation of around £3.5trn. Its focus has historically been on large, state-owned operations that have been key catalysts for the country’s economic growth.

China’s smaller mainland stock market is the Shenzhen Stock Exchange. It has a market capitalisation of around £2.3trn. Since a larger proportion of its constituents are smaller companies that may be more innovative than many of the state-owned businesses listed on the Shanghai Stock Exchange, the Shenzhen Stock Exchange is viewed by some investors as being more representative of the future growth potential that the country offers.

Therefore, investors seeking to passively invest in China may wish to focus their capital on both exchanges through the CSI 300 index. It is a capitalisation weighted index composed of the 300 largest stocks traded on the Shanghai and Shenzhen stock exchanges.

The index could provide investors with a representative exposure to the economy as it undergoes a transition from manufacturing-led growth to an increasing focus on services.

Japan

Japan’s flagship index, the Nikkei 225, is comprised of 225 of the country’s largest companies. The index seeks to maintain a balance between different sectors of the economy in order to make it representative.

Companies within each sector are chosen based on their liquidity, with the most liquid stocks being included in the index.

Although the Nikkei 225 contains a relatively large number of stocks, the alternative TOPIX index provides access to a broader range of companies. It contains all companies in the First Section of the Tokyo Stock Exchange, which are the country’s largest listed companies.

The First Section amounts to over 2,100 companies in total, which could make the TOPIX index more representative of the wider Japanese economy than the Nikkei 225.

Furthermore, the Nikkei 225 is a price-weighted index. This means that companies with higher share prices have a greater impact on its price level than stocks with lower prices.

By contrast, the TOPIX index is weighted by market capitalisation. This leads to larger businesses having a greater impact on the price level of the index than smaller companies, which may be a more accurate reflection of trends in the real economy.

Verdict

Passive investing continues to be an effective means of gaining exposure to a variety of economies across the globe. It reduces company-specific risk through diversification, while potentially offering lower costs compared to investing directly in a large number of stocks.

However, in some cases a country’s most widely-known index may may fail to reflect the wider economy.

Therefore, it seems logical for investors to consider less well-known indices when they are aiming to gain exposure to a specific country’s economy. Doing so may provide them with a more accurate reflection of domestic economic performance, rather than additional exposure to the global economic outlook.

Robert Stephens is a financial writer

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