Too embarrassed to ask: what is an index?

The FTSE 100 is probably the best-known stockmarket index in the UK. But what exactly is an index?

Even if you couldn’t care less about investing, you’ve probably heard of the FTSE 100. The FTSE 100 is the best-known stockmarket index in the UK. In effect, it sums up the fortunes of Britain’s biggest listed companies into one single number, by combining them all into one hypothetical portfolio. 

Why is this useful? It gives a representative snapshot of how strong or weak the market in big UK companies is at any given point in time. But more importantly, it serves as a useful benchmark. 

If you invest with a fund manager who says they will put your money into big UK companies, then how do you know if they are doing a good job or not? One way to tell would be to compare their performance to that of the FTSE 100. If they manage to beat the index over the long run, it suggests that their stockpicking skills are adding some value for you. If not, then why pay them to manage your money? 

There are many different ways to construct an index. Most indexes, including the FTSE 100, are based on market capitalisation – that is, the share price of each company multiplied by the number of shares outstanding. In other words, the companies deemed most valuable by investors carry the most weight in the index.

The best-known indexes tend to be the ones that represent individual countries’ stock markets. Other indexes you may well have heard of include the Dow Jones or the S&P 500 in the US, and the Nikkei in Japan.  However, there are literally thousands of different indexes available, and there are many different ways to build them.  

As passive investing – which aims to track an index, rather than beat it – has boomed in popularity, index providers have become huge businesses. As investor demand for index funds that track specific themes, or specific investment styles has grown, index providers have created custom indexes to back these investment products. 

Some fear that the boom in indexing may distort the flows of money into financial markets in disruptive ways. However, there is no doubt that index funds can be a very convenient and cheap way to build a diversified long-term investment portfolio.

To learn more about index investing, subscribe to MoneyWeek magazine.

Recommended

Government expected to delay increase in state pension age to 68
Pensions

Government expected to delay increase in state pension age to 68

The increase in state pensions age to age 68 could be shelved amid concerns over falling life expectancy.
22 Mar 2023
Bank bailouts are bullish for bitcoin and gold
Investments

Bank bailouts are bullish for bitcoin and gold

The collapse of Silicon Valley Bank and Credit Suisse has shaken investor confidence in the global financial system. Dominic Frisby explains what this…
22 Mar 2023
What is happening to house prices?
Personal finance

What is happening to house prices?

House prices may have been slowing down, but asking prices are on the rise. We look at the latest on what is happening to house prices as ONS releases…
22 Mar 2023
Five changes to state pensions coming next month
Pensions

Five changes to state pensions coming next month

There are several changes happening to state pensions in April. We explain what’s happening.
22 Mar 2023

Most Popular

Rightmove: UK house prices up £3,000 as property market rebounds
House prices

Rightmove: UK house prices up £3,000 as property market rebounds

Rightmove’s latest house price index shows the property market has been resilient despite an economic downturn
20 Mar 2023
Can I avoid IHT by stuffing all my money into a pension?
Personal finance

Can I avoid IHT by stuffing all my money into a pension?

The ditching of the lifetime allowance could enable millions of pension savers to avoid inheritance tax. We explain how.
20 Mar 2023
Will energy prices go down in 2023?
Personal finance

Will energy prices go down in 2023?

Ofgem’s price cap is now predicted to fall below £2,000, based on average typical use, from July, for the first time since 2022. We have all the detai…
21 Mar 2023