FOOL SCHOOL
Introducing The Index Tracker

March 9, 2005

An index is a method of tracking how well an investment is performing. There are indices for the stock market, the bond market, the housing market and so on. These indices enable investors to see how their own performance compares against the market as a whole. This way, they can see if they are outperforming (doing better than the index) or underperforming (not doing so well).

A stock market index consists of a number of companies. The level of the index is based on a calculation of the average of all its constituent companies' share prices.

When you hear on the news that the "Footsie has risen 100 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 100 points actually mean? Say the index rises by 100 points from 5,000 to 5,100, or 2%. This means that the value that the stock market is placing on all the companies within the index has gone up by 2%. 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 your good self.

In most indices, the calculation of the index number is made by weighting each company's share price according to their size. So the movements of large UK companies such as BP (LSE: BP.) and GlaxoSmithKline (LSE: GSK) have a much more significant impact on the movements of the FTSE 100. Usually the index starts off at some sort of round number. For example, the FTSE 100 began life at the 1,000 level back in January 1984. You can see how it has done in the last 10 years here.

One complication you should be aware of is that most indices don't include the dividends paid out by their constituent companies. Dividends make up a significant element on the returns generated by shares so bear this in mind if you want to compare the performance of any of your investments against an index. Indices that include dividends are often referred to as Total Return Indices.

Types of Share Indices

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 Allshare -- the largest 700 or so companies.
FTSE techMark 100 -- the largest 100 technology-based companies.
FTSE 250 -- the 101st to 350th largest companies (often referred to as the mid caps).
FTSE 350 -- the 1st to the 350th largest companies.

In the US major indices include the Dow Jones Industrial Average (the Dow), the S&P 500 and the Nasdaq (where most technology shares are listed). Others you may come across include the Nikkei (Japan), the Hang Seng (Hong Kong), the Dax (Germany) and the 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. Note that most indices just track the capital value of each share - in other words, they don't include dividends. So, if you want to compare an investment to the overall market, then you'll need to take dividends into account as well.

A index tracker is a fund that attempts to emulate the performance of a particular index. It does this by owning the same shares in the same proportion as the index it tracks. The managers of these funds make no decisions as to which shares to buy they simply follow the index. Any dividends earned by the shares are paid out as income, usually less any expenses incurred by the fund. This is known as passive investing. Most fund managers employ active investing, selecting for themselves which shares to buy and sell and when. These funds are often known as managed funds.

In Friday's Fool School, we'll look at how index trackers work in more detail. In the meantime, why not pop into our Tracker centre?