The Week Explained: Indices

PUBLISHED : Monday, 01 October, 2012, 12:00am
UPDATED : Monday, 01 October, 2012, 1:21am

When investors talk about how a stock market is performing, they usually think of a benchmark index, such as the Hang Seng Index for Hong Kong, or the Dow Jones Industrial Average for New York. However, a recent debate over the Dow Jones highlights the difficulties with this assumption.

The problem is that three of America's largest and most influential companies - Apple, Berkshire Hathaway, and Google - are not included in the 30-member index. Thus, Standard & Poor's, which now controls the Dow Jones, is wondering whether these need to be part of the benchmark index to make it more representative.

It's a problem because if they were included, they would dominate the index, which might misrepresent how the market as a whole is performing. However, a benchmark index that lacks some of the biggest players can also be accused of being misleading. There is no easy answer.

Indices such as the Dow Jones are proxies for the market as whole and should be reliable indicators as to how the market is performing. In this light, the difference between this year's performance of the Dow Jones compared with the wider Standard & Poor's 500 Index is instructive. The former is up by over 11 per cent since the beginning of this year, and the latter has risen about 16 per cent.

The situation in London is more intriguing. The benchmark FTSE 100 is up some 4 per cent on the year, but the FTSE 250 - which covers the most highly capitalised companies outside the FTSE 100 - is up over 16 per cent. The FTSE 350, which combines the 100 and 250 indices, rebalances them with a rise just below 6 per cent this year.

This mirrors the FTSE All Share Index, which covers all shares on the market's main board. This index is up about 6 per cent on the year.

So it could be argued that the best way of viewing the London market would be to follow the more comprehensive benchmark, such as the FTSE 350 or the All Share Index, but neither index has the prominence of the FTSE 100.

Here in Hong Kong, we have the benchmark Hang Seng Index, composed of 49 counters, covering almost 63 per cent of the entire market's value and 54 per cent of its turnover. This index, founded in 1969 but backdated to 1964 for benchmarking purposes, has maybe undergone a more profound transformation than any other major index.

In 1964, the index was dominated by the big hongs, such as Jardines, Swire and Wharf. There was only one bank, the Hongkong Bank, no China stocks, and a few industrial and transport companies - all of which have long since left the list.

Today the biggest components of the Hang Seng are financial companies followed by energy and telecommunications. H shares, other mainland companies and red chips account for over half of the companies in the index. HSBC retains the highest level of weighting, but it is one of a small group of companies that have had a dominant presence since the index was established.

The reality of mainland-related shares' importance to the Hong Kong market is clearly reflected in the index, but as in other global indices, dominant shares distort the measure of the overall market performance. This year the Hang Seng is performing far better than the market as a whole, up some 13 per cent since January, whereas the Hang Seng Composite Index, covering some 95 per cent of the market's total capitalisation, is up only 10 per cent.

The differences among various indices for the same market have become more significant, not least because investors are moving more towards investment in exchange-traded funds or ETFs. These follow various market indices but tend to focus on the major index.

Some hold a belief that ETFs axiomatically reflect overall market performance. But, as we have seen, they tend to reflect one, admittedly major, aspect of the market - the index - but not its entirety. This may not matter, but investors should be aware of the differences.