FOOL'S EYE VIEW
How To Choose Which Index To Track

By James Carlisle
July 8, 2002

It's an investment truism that, given two funds investing in the same universe of shares, then the one with the lowest charges has the best chances of coming out on top. The charges are like a leak in the portfolio - drip, drip, drip - and, other things being equal, the smaller the drips, the more money there's likely to be in your investment pot. Index trackers tend to be the cheapest collective investments, so it's no surprise that they also tend to do better than the vast majority of actively-managed investment funds over the long-term. So, on principle, index trackers make good sense, but which index should you track?

Market Portfolios

As well as lower charges and likely out-performance, some index trackers have another string to their bow, because they give you the average performance of the stock market.

In some circles, being average is not what you're after. After all, Steve Redgrave didn't win five Olympic gold medals by concentrating on an average performance. But investment isn't like rowing. We all have to do it -- otherwise we won't be able to pay for those corn plasters and Saga holidays in retirement. What's more, a below average result is at least as painful as an above average result would make us happy. In short, in terms of investing for your future, you'd settle for the average rather than gambling for a better than average result.

The way you reflect the average of the overall stock market is by including the different companies in proportion to their size. (see How Do Index Trackers Work?) There are three indices on the London stock market that aim to do this: the FTSE All Share Index, the FTSE 350 Index and the FTSE 100 Index.

The FTSE All Share Index

Despite its name, the FTSE All Share includes only 719 of the 1,600 or so UK companies listed on the London stock market. However, those 719 (or whatever -- it does change) companies currently represent about 98% of the overall value of the market. Not only that, but if one of tiddlers outside the index started to do well, and get a bit bigger, then it would soon get added to the index. So the FTSE All Share index is going to give you a very accurate reflection of the London stock market's average performance.

The FTSE 350 Index

The FTSE 350 Index is an index of, wait for it, the biggest 350 companies on the London stock market. It's very important not to get it confused with the FTSE 250 Index. The FTSE 250 (roughly speaking) comprises the 101st to 350th biggest companies and, by excluding the 100 biggest companies (aka the FTSE 100, which we'll come to in a moment), it misses out on about 82% of the London stock market's value (and therefore doesn't come close to reflecting the market's average performance).

Anyway, the FTSE 350 Index is the combination of the FTSE 100 (see below) and the FTSE 250 index. The overall market value of these 350 biggest companies is some £1.28 trillion, or about 94% of the London stock market. And of course, as soon as a company started doing quite well and got up to 350th on the list, then it would get included in the index. So the FTSE 350 Index should provide a pretty accurate reflection of the overall performance of the London stock market. Not quite as accurate as the FTSE All Share, but not far off.

The FTSE 100 Index

Then there's the FTSE 100 Index, comprising the 100 biggest companies on the London stock market, in proportion to their market value. This is the one that they're talking about on the news when they say 'the FTSE's up, the FTSE's down'. At the moment it stands at around 4,600, which gives the top 100 companies on the London stock market a value of about £1.1 trillion and that's about 82% of the total London stock market.

So which index is best?

Overall then, there's not much between the different indices. Think of it like this, the FTSE 100 is the 100 biggest companies. The FTSE 350 is then 87% made up of the 100 biggest companies, with the other 13% made up of the next 250 biggest. The FTSE All Share is about 84% made up of the 100 biggest companies, about 12% made up of the next 250 biggest companies, and about 4% made up of a load of tiddlers.

If we're forced to choose, then there are a few factors that we could look at. The trouble is that it always seems to be a case of six of one and half a dozen of the other. The FTSE All Share has a heavier exposure to smaller companies and there are some grounds for saying that these might do better than the big ones over the long term (because they're riskier, investors might price them so that they give higher returns to compensate). Then again, you could argue that the big companies might do better. In an increasingly global economy, the big powerful companies might just crush the little ones.

Then there's the fact that the FTSE All Share, with its 719 companies and 98% of the market's value, is a broader index and that much more likely to reflect the market's average performance. Then again, more companies might just make it harder for an index tracker to track it cheaply and accurately. But you have to decide how accurate you want to be. Just by having the FTSE 100 and a few more, in the right proportion, a FTSE All Share tracker is going to be tracking the market average more accurately than a FTSE 100 tracker.

The FTSE All Share is best, maybe

Okay, enough of the waffle [yes, please get on with it Jimmy -- ed], I'll change the habit of a lifetime, get off my fence and say...I reckon...perhaps...that FTSE All Share trackers are best. There are two main reasons. First of all, it's that much closer to representing the overall market average and that, after all, is one of the fundamental things we're trying to achieve. The other reasons is that the quarterly reclassifications are less of an issue.

Once a quarter, the FTSE committee sits down to work out what the new biggest 100 companies are. If a company has slipped beneath 100th place, then it gets kicked out and, if one rises above 100th place, then it gets included. The same happens with the FTSE 350 and the FTSE All Share, but the companies involved are that much smaller.

Anyway, the theory goes that, when these reclassifications take place, the share prices of the new inclusions (and of the rejects) might be distorted by index trackers rushing to buy them (and sell the rejects). There's very little evidence for it, but since the companies at around 100th place only account for about 0.15% of the index, even paying 10% too much (or receiving 10% too little) for them might make, heavens, a 0.015% difference to the index. A number like 0.015% might matter if you're planning a moon landing but, in investment terms, it's going to be dwarfed by other factors.

So, if you want my opinion, then All Share trackers are the best, but there's very, very little in it and even less that you can be even vaguely confident about. So long as you go for the FTSE All Share, the FTSE 350 or the FTSE 100, then you should come very close to your aim of matching the market average. After that, finding low charges will be the most important factor.

More: The Fool's Index Tracker Centre.