The 10 best indices to track

There's a problem with ETFs. They provide a simple, efficient and cheap solution to lots of investment difficulties yet private investors have been slow to buy them. There are several reasons for this including our continued love affair with star fund managers. But a bigger problem is probably what's been called the 'biscuit tin' problem - defined by one chief executive of an ETF firm as "investors not knowing what the heck our ETF actually tracks. We'd say it tracked the so and so MSCI index and they'd look at us blankly. Why would they know what the index is, it's nothing you talk about down the pub. It's much easier to talk about that star manager so and so who's made your best mate a small fortune". This brutal assessment gets to the heart of the problem. A good index tracking fund can and should be one of the core components of any diversified portfolio but you need to understand what the fund is actually tracking first.

It's all about the index

Indices are not all equal. Track an imperfect index that's poorly constructed, over weight in just a few shares (say banking stocks in 2008) and you'll end up destroying a large chunk of your money despite all the talk about efficient markets and perfectly optimised portfolios by academics. Luckily investors have a huge range major markets that can be tracked using mainstream indices - nearly all the big asset classes and markets boast an index that's become a part of everyday language. In the US, for example, the level of the Dow Jones Industrial Average or the S&P is the subject of intense daily discussion on a number of major news programmes while here in the UK, all the major news organisations talk hourly about the current level of the FTSE 100 index of major London listed blue-chip shares.

Indices are mathematical constructs, which are marketed as brands to both institutional and private investors - they're a shorthand way of 'capturing' the changes in major markets. The number of these index 'brands' has increased exponentially in recent years with major providers such as Dow Jones, MSCI, S&P and FTSE turning into research houses sporting every kind of niche index imaginable - the FTSE Group, for example, calculates over 120,000 indices covering more than 77 countries and all major asset classes.

The key for investors is to work out which indices - and markets - really matter and then work out how best to invest in these markets. In many liquid, mature markets index tracking funds are probably the cheapest and arguably the best way of buying long-term exposure although over shorter terms there's no doubting that active fund managers can add value. Equally, some of the less mainstream markets are probably better suited to active fund managers - there's a huge array of ETFs that track the big emerging markets but many analysts reckon that an active fund manager can do a better job of navigating around these risky, volatile markets. Remember that an index tracking fund will only ever buy the most popular stocks that are increasing in value - it's a giant weighing machine that is heavily influenced by momentum, so if a market and thus an index is overweight popular mining stocks, expect the ETF to be equally overweight.

The key for investors is to work out which indices to track, how many to include in their portfolio and then work out the best way of buying that exposure to the market - called access to beta in the trade. Here at the Financial Times Group, we've published a new book on ETFs and Index funds containing a list of the top 25 Essential indices that most investors should consider as part of a diversified portfolio but we've shortened that down to the top 10 Essential indices for the Investors Chronicle.

BOOK DETAILS

The bookshop details are www.pearson-books.com/etf (offering IC readers a 35 per cent discount)

The Financial Times Guide to Exchange Traded Funds and Index Funds is a comprehensive and authoritative introduction to this new way of running an investment portfolio. It explains what index tracking funds are, how they work, compares different fund types and provides a coherent investing master plan. Proving that the best investment strategies really are based on easy to understand principles, The Financial Times Guide to Exchange Traded Funds:

• Shows you how to use ETFs, what to watch out for and advises on the very real risks;

• Suggests actual portfolios of mixed ETFs for you to start with;

• Gives you 25 essential indexes that you should be following.

The UK - the FTSE 100 or the FTSE All-Share?

In the UK the first big decision is whether to track the FTSE 100 (known as the Footsie) or its related sibling, the FTSE All Share index which comprises around 98 per cent, by value, of all stocks listed on the London Stock Exchange. The 100 stocks in the FTSE 100 comprise the largest quoted companies on the London Stock Exchange – it’s the premier index for large, blue chip companies. As of the beginning of January 2010…

1.Those 100 top stocks are valued at a total of £1,404m

2.The top 5 stocks are valued at a total of £429bn

3.The top 10 stocks are valued at £644bn

4.The bottom 50 stocks are valued £171bn

5.Some companies in this list have risen in value by more than 474 per cent in the last year (Kazakhmys), others have dropped by more than 40 per cent over the same period (RBS)

6.The top stock – HSBC – comprises 8.7 per cent of the entire market cap while the bottom stock , the London Stock Exchange itself, comprises just over 0.1 per cent of the entire market cap of the FTSE 100.

Should you track the FTSE 100? If you want to track the main component of the UK listed market comprising the most liquid companies, this is the index to use. But be aware that it is by its very nature heavily concentrated on the biggest companies, and many of those companies have a very strong foreign business presence. It’s estimated that up to 60 per cent of the turnover of FTSE 100 companies is earned in either dollars or euros. In a note before Christmas Brewin Dolphin equity analyst Edmund Salvesen remarked that although HSBC, Vodafone and BP might seem quintessentially English – “In fact these three stocks have only 22 per cent, 13 per cent and 33 per cent of their revenue base from the UK respectively, the rest is all overseas. Indeed, the widely held view that the UK only makes up a third of FTSE 100 revenues is also incorrect. UK exposure in the main indices makes up just over 25 per cent, only a quarter!” Salveson went on to note that exposure of the FTSE 100 to Europe ex UK is 20 per cent alongside 18 per cent to Asia Pacific, the Middle East and Africa.

Some institutional investors prefer to track the FTSE All-Share – like nearly all the indices in this list it’s a market-capitalisation weighted Index representing the performance of all eligible companies listed on the London Stock Exchange's main market. On paper its sounds a much more comprehensive index than the FTSE 100 but it’s still weighted by the size of the market cap - the top 10 companies in the FTSE All Share comprise 39% of the index as opposed 45% with the FTSE 100 while in overall terms the FTSE 100 comprises 85% of the FTSE All Share. So although the FTSE All casts a wider net, it’s still focussed on mega-cap blue chips.

But there’s another crucial point – the FTSE All is not actually ALL the market as the title might imply. It doesn’t include some really tiny companies that comprise the ‘fag end’ of the market, namely micro-caps in the FTSE Fledgling Index i.e really tiny companies valued at less than £10m. There’s a multitude of these very small companies but they don’t really amount to much in ‘economic size’ or footprint so they’re not covered by the FTSE All Share. So when you buy this index, don’t think you’re actually buying ALL the UK market – no one index captures that!

So FTSE 100 or FTSE All – which one should you invest in ? If you want a broader market consider using the FTSE All Share as it is more comprehensive and includes the FTSE 250 and the FTSE Small Cap. If you want a more focused large cap index, go for the FTSE 100. But don’t buy both – you’ll be effectively duplicating a lot of the holdings and the FTSE All Share index tends to move in the same direction as the FTSE 100 and so you won’t get much diversification benefit.

How to buy access to these indices?

The funds that track the 100 index tend to split into two broad categories – a wide range of unit trust trackers and a small number of exchange traded funds. By and large the ETFs tend to be cheaper than the unit trusts although the Vanguard, Fidelity and HSBC OEICs are very competitive in pricing terms. But cost isn’t the only factor – you also need to concern yourself with what the experts call tracking error. This is the difference between the underlying index and the fund returns – in the FTSE 100 table below we’ve looked at the difference in returns over the 12 months to 31 December 2009. Over these 12 months the FTSE 100 returned 22.7 per cent but some funds delivered just over 20 per cent while some returned over 27 per cent - a difference of more than 7% per cent.

TAKE IN FTSE 100 TABLE

The FTSE 250

This hugely under-rated and arguably under-reported index offers investors three big plays – the UK as a distinct national economy, plus a profusion of growth companies and much greater diversification compared to the FTSE 100. It’s also worth noting that over much of the last 10 to 20 years the index has also offered better returns with lower volatility.

The FTSE 250 index is a crucial index because it’s very much focused on UK Plc as an economy, with companies that will genuinely capture the future growth potential of the British economy, mostly through sterling based earnings. Obviously in a recession, that UK focus is something of a weakness and the larger cap indices with their globally diversified components might seem like a safer play. But FTSE 250 also tends to be jam-packed full of faster growing companies, many of them having risen from the FTSE Small Cap index, with more than a few on their way up into the FTSE 100. Again that growth profile is also a weakness in bear markets as growth companies can find themselves going ex growth, with the inevitable consequences for the share price. Many investors are also strongly attracted by the diversification on offer in this index - those 250 companies (actually many index trackers have 252 funds) include a huge range of companies and the top holdings comprise much less than 5 per cent of the total index value. It’s also worth noting that the FTSE 250 comprises just under 15 per cent of the wider FTSE All Share index.

There are also some equally obvious weaknesses with the FTSE 250 – it’s still very focused on financial companies and there are a large number of big investment trusts that tend to dominate the index alongside a chunky number of industrials. Should you buy it? The FTSE 250 is one for more risk friendly investors who don’t mind taking on the potential for greater rewards - it tends to rise faster and fall faster than its bigger siblings (the FTSE 100 and All Share). As for funds there’s one major unit trust tracker from HSBC plus three cheaper ETfs from iShares, Lyxor and Deutsche, all of whom charge less than 0.50 per cent.

The FTSE All Stocks Gilt

This index’s full title is actually the FTSE Actuaries Government Securities UK Gilts All Stock Index and it gives exposure to a diversified basket of UK government bonds, across all maturities – all in the conventional space, that is, there are no index linked holdings within this exclusively sterling denominated fund. That makes this index a brilliant tool for buying into a diversified basket of what are called conventional government securities, otherwise known as gilts.

The index isn’t well known and there’s currently only one ETF that tracks it – details are in the box below - but this is probably one of those potential core holdings for any investor looking for an easy way to diversify away from equities towards bonds. Remember that if you want bonds exposure, you’re safest bet is probably gilts and if you want the best basket of sterling gilts this index gives you that in spades. What’s even better is that the lonely iShares ETF that covers this index is incredibly cheap – the total expense ratio is just 0.20 per cent. One note of caution though – you probably shouldn’t buy into this index if you think inflation is about to shoot up, if only because conventional gilts tend to do badly in these circumstances. Investors worried about inflation should consider using funds that track index linked gilts in the UK – these are mostly provided by BarCap.

TAKE IN TRACKING GILTS TABLE

The FTSE Small Cap Index

The FTSE Small Cap index consists of companies too small to be included in either the FTSE 100 or FTSE 250 (which combine to form the FTSE 350) but big enough to be included in the FTSE All Share index. The index currently comprises 260 companies and represent approximately 2 to 3 per cent of the UK market capitalisation with an aggregate value of £37bn. The market capitalisation of companies in this index varies between £30m and £320m.

In the US small cap indices like the Russell 2000 are a big business – dozens of funds (tracker or otherwise) follow the small cap segment of the US market. Here in the UK by contrast, small cap investing is exclusively the preserve of actively managed funds – there are no small cap index trackers in the UK and not one ETF or unit trust tracker follows the all important FTSE Small Cap index or the FTSE Fledgling Index which tracks really small companies that aren’t even big enough to make it into the FTSE Small Cap Index. This absence of tracker small cap tracker funds in the UK is a huge pity because small cap investing works – academic evidence points to the fact that small cap investing delivers superior returns over the long term despite the increased risks.

TAKE IN Top stocks in the FTSE Small Cap index TABLE

FTSE World exc UK

This ‘mega-index’ represents a very simple idea – when investors are looking to diversify internationally why not buy into one index (and tracker) that follows a big, aggregate index of nearly all the developed world’s stock markets? That’s the idea behind global indices that track developed world markets. There are two big rivals for the global index business – the most successful index family is based around an index called the MSCI World index which includes the UK market (about 10 per cent of total holdings). Its potentially more compelling rival is the FTSE World exc UK index- this index is enormously useful to British investors because most of us are already far too biased towards UK stocks and this index specifically excludes UK stocks. What’s even better is that both of these huge global index families are very diversified - in both cases (the MSCI World and FTSE All World) you’re buying into a portfolio of companies where the top three companies only comprise between 5 and 9 per cent of the total holdings. There is one downside though – you are buying a heavy mix of US stocks which comprise between 40 and 50 per cent of total holdings.

TAKE IN Tracking the Global Markets TABLE

Europe – The DJ EuroStoxx 50

Mainland, continental Europe, with huge stock markets such as the CAC 40 in France and the DAX in Germany, is one of the most interesting investment spaces readily accessible to private investors here in the UK. A number of important selling points immediately jump to mind – mainland Europe boasts a huge range of impeccable blue chip companies, many of whom pay out some very decent dividend yields as well as offering great growth prospects. The Euroland markets – a term applied to those countries that have utilised the Euro as their currency – also offer a first rate collection of export orientated companies with a particularly strong focus on banks (outfits like Santander for instance), oil companies (Total) and capital equipment companies dominant in virtually every form of engineering imaginable. The Euroland markets are also, on some measures, fairly good value – the table below shows key valuation metrics for the most popular blue chip index, something called the DJ Eurostoxx 50. On most key measures this broad index is cheap compared to its US and UK siblings !

KEY VALUATION MEASURES FOR DJ5 0

Price/Earnings Incl. Negative

Trailing 18.49

Projected 10.88

Price/Book

Price/Book 1.41

Dividend Yield (%)

Dividend Yield 3.21

Price/Sales

Price/Sales 0.73

Price/Cash Flow

Price/Cash Flow 4.43

The Blue Chip Index

The main index worth tracking is called the Dow Jones EuroStoxx 50. It’s the bellwether index and is probably the biggest, and the most tracked European index for Eurozone Blue Chip outfits like Total or Siemens. According to index developers Dow Jones it aims “to provide a Blue-chip representation of ….leaders in the Eurozone” and includes companies from Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. Although the DJ Eurostoxx 50 is hugely popular, there are rival indices (and accompanying index tracking funds) from both the FTSE Group and MSCI, some of which include the UK.

TAKE IN DJ EuroStoxx 50 composition as at end of October 2009 TABLE

MSCI Emerging Markets

Emerging markets sound like a great story – these feature some of the fastest growing nations on earth who also happen to boast some of the most successful stockmarkets, with hundreds of fast growing companies. It’s a growth investor’s dream but there’s an awkward reality – most of these markets are inaccessible to foreign investors and the sheer amount of choice is overwhelming. Luckily there is an answer – the well established MSCI Emerging Markets index or MSCI EM for short. It’s widely used by the institutions as a benchmark index and comprises all the world’s main emerging stock markets in one composite index.

Over the last 20 or so years, returns from this index have been spectacular, even after the mauling of 2007-09. For investors looking to access this extraordinary growth the best choice is the simplest – a fund that either tracks or benchmarks the MSCI EM index. All the big ETFs that track the global MSCI EM space are cheap, fairly diversified across different countries (although resources do tend to figure heavily) and biased towards the biggest and best companies in the global emerging markets space. These diversified funds are probably a better idea compared to any of the more specific country or region specific indices or funds although particularly adventurous types might want to consider some interesting alternatives which focus on emerging markets small caps – they’re still part of the MSCI index family and tracked in turn by iShares ETFs. The first is called the MSCI Asia ex Japan Small Cap index - it’s hugely diversified on a number of levels, with a great variety of nations and different sectors (Taiwan 29 per cent, South Korea 22 per cent, Hong Kong 13 per cent, and China 12 per cent with Financials, Industrials, Technology all fairly evenly represented). There’s also the MSCI Emerging Markets Small Cap index which is defined as any company within the MSCI EM index with a market cap of between $200m and $1.5bn. This little known index started in 1998 and by its peak in 2007 had quadrupled in value but in the bear market of 2007 and 2008, the index crashed back in value but it’s still well ahead of its starting levels in 1998.

More adventurous investors might also want to look at the small number of BRIC indices – these track the markets in Brazil, Russia , India and China with the FTSE variant focussing on the 50 largest companies in the developing world (it includes outfits such as Petrobas from Brazil and Gazprom from Russia).

These BRIC mega-cap indices are a potentially brilliant idea for an investor looking for a very focused investment but there are some potentially big flaws. Well over 60 per cent of the value of the index is accounted for by big Russian and Brazilian companies with India and China comprising a rather measly 38 per cent between them.

Finally, it's worth bearing in mind one last overall caution with all Emerging Market’s indices – there are some very strong arguments that suggest that many emerging markets like China and Russia are deeply inefficient with huge risks beyond just excessive volatility. Corporate governance, political interference and outright fraud are key concerns in the EM space and investing in a fund with an active fund manager might be a better idea in some cases.

TAKE IN TABLE OF % returns from MSCI EM index

The US Market

Nearly every internationally diversified portfolio should have some exposure, no matter how small, to the US – that could be done indirectly through a World Developed Markets index with a heavy US weighting or directly through an index which tracks a major US index, of which there are, unsurprisingly a great many choices. These include:

• The major one which is the S&P 500 - a value weighted index published since 1957 which comprises the prices of 500 large cap liquid stocks actively traded in the USA. Companies that comprise the S&P 500 trade on either the New York Stock Exchange or the NASDAQ.

• The Dow Jones Industrial Average which is a price-weighted average of blue-chip stocks and the oldest index by far. The index covers all industries with the exception of transportation stocks and utilities – they have their own specific indices. The DJ index has been a widely followed indicator of the stock market since 1 October 1928 but it's much narrower than the S&P 500 and comprises just 30 mammoth companies

• You might also see another major index used called the Russell 1000 Index which measures the performance of the large-cap segment of the U.S. equity universe. According to ETF Securities (which has an index fund that tracks this index) the 1000 represents approximately 92 per cent of the U.S. equity market vs. only 66 per cent for the S&P 500

• THE MSCI USA Index. This is based around the hugely popular MSCI World Developed markets index and covers almost 98 per cent of all the stocks – large and small – listed on the US stock markets (including the NASDAQ and the NYSE).

Which index to use? Given this huge range,I'd suggest sticking with perhaps the best known of the large cap indices namely the S&P 500 index – it's hugely diversified compared to our own FTSE 100 and contains some of the world’s strongest companies. It’s also easy to track, and the underlying shares are hugely liquid and easy to access.

TAKE IN Tracking the US Market via ETFs TABLE

Japan - The TOPIX , MSCI Japan and the Nikkei 225

When most investors talk about Japanese stocks they usually talk about the price movements in something called the Nikkei 225 index – it’s the most widely used measure of Japanese although bizarrely it’s not actually tracked by any major ETFs in the UK. The most widely used index is actually a subset of the MSCI World index and is called the MSCI Japan index, although many fund managers also choose to use called the TOPIX , managed by the Tokyo Stock Exchange – this latter index is especially popular with structured products providers and ETF companies like Lyxor. The TOPIX covers much of the same ground as the Nikkei but with a wider spread of companies and sectors - ie it’s slightly less concentrated than the Nikkei. The MSCI Japan Index is an institutional construct based on the widely used MSCI index series and includes virtually all the companies that are found on the TOPIX index.

TAKE IN Tracking the Japanese indices using ETFs TABLE

Commodities

When most ordinary investors think of commodities they tend to think of the spot price’s that are quoted in the media but in reality most professionals tend ignore this as an investable idea – they tend to use an index that incorporates some form of futures contract across a range of different commodities, called in the trade a composite index. In technical language this means that these commodity indexes represent the total return of something called a non-leveraged (no loans involved) futures portfolio. Simply put, that means the full contract value of a futures contract — not just the margin requirement — nominally secures each position in the index.

The returns from these futures based commodity index come in three different ways: the interest earned on that collateral deposited to secure the futures positions (typically you pay an advance as a deposit, based on collateralised Treasury Bills on which you earn income), the return obtained from holding and trading futures themselves (based on moves in the underlying spot price) and something called the roll yield. In reality changes in the spot price are sometimes drowned out by movements back and forth in the roll yield and thus this roll yield is a crucial part of total index returns – these futures indices capture the "roll" from one contract to another, selling the expiring contract and buying the new one. The next month's/quarters contract frequently changes in price - if it costs more, the market is in "contango” and the investor loses out, while if it costs less the market is "backwardated” and you make money. The existence of contango indicates, among other things, that there are adequate supplies to be carried into future months. This roll yield is hugely important long term and probably accounts for a large component of total long term returns – one set of analysts at US based website HardAssetsInvestor.com charted returns for 2008 from the roll yield and found a huge range of returns, ranging between -94 per cent for lean hogs through to 44.6 per cent for heating oil.

The Main Commodity Index providers

If all these varying components to total returns from investing in futures indices hasn’t completely foxed you, you’ll soon be confronted by an even more confusing sight – the sheer range of index providers who offer major investable indices in this space.

The S&P Goldman Sachs Commodity Index is perhaps the most widely used index and is what’s called a “production-weighted benchmark” of two-dozen commodities adjusted for liquidity - currently its heavily weighted in energy products; 40 per cent of the index's weight comprises crude oil futures. Agricultural and soft commodities, such as wheat and sugar, make up 11 per cent, metals 6 per cent and livestock 2.86 per cent. Because the GSCI index is based around this notion of ‘world production’, the constituents can vary widely – the dominant energy sector for instance has varied over time from 44% per cent through to 78 per cent, making it very volatile indeed!. This also makes SP/GSCI most susceptible to the effect of rotation between contango and backwardation in crude oil prices.

The Dow Jones-AIG Commodity Index is an equally popular series of indexes and sits at the core of the ETF Securities range of funds. It’s made up of 19 commodities weighted primarily for trading volume, and secondarily based on global production, with index rules “designed to dampen volatility” by setting floors and caps on component weights. Crucially the index has been set up so that no single commodity can comprise more than 15 percent of the index, and no single sector can make up more than a third of the benchmark's weight. By sectors, energy now carries the biggest weight of 33 percent, followed by industrial metals at 20 per cent, precious metals at 10, softs at 8.7 and grains at 18 per cent. This index series is used by ETF Securities in the UK and the iPath range of ETNs in the US. DJ-AIGCI is the most evenly balanced across all five sectors, which means it captures much of the contango in Livestock, Agriculture and Precious Metals, without the luxury of having a larger presence in the Energy Sector where the backwardation is rife.

The Deutsche Bank Liquid Commodity Index consists of only six commodities, based around the most liquid (in trading terms) commodities in each sector. The index company claims that this narrow range of underlying commodities reduces that actual cost of roll and rebalancing. In practical terms it means that Energy makes up 55 per cent of DBLCI; agriculturals and metals equally split the remaining 45 per cent. There is no exposure to livestock or softs in this index family. Crucially the designers of this index – and the Powershares range of ETFs that track it – claim a unique "roll strategy". Rather than simply rolling expiring contracts to the next available month, DBC looks out as far as 13 months for the contract with the highest "roll yield". Theoretically, the index developers claim, this should improve roll yields in both backwardated and contango-ed markets. DBLCI holds only six commodities: Heating Oil, Light Crude Oil, Wheat, Aluminum, Gold and Corn.

Lyxor, an ETF provider in the UK, boasts a small family of index funds that track a venerable and widely followed index called The CRB Commodity Index, started by the Commodity Research Bureau back in 1981. This index is made up of 22 futures contracts combined into an "All Commodities" grouping, with two major subdivisions: Raw Industrials, and Foodstuffs. Metals make up 20 per cent, energy carries a weight of 39 per cent and soft commodities 39 per cent.

Last but by no means least, many commodity purists rather like something called the Rogers International Commodity Index which is by far and away the broadest and most international of all the indices. The RICI consists of 35 commodities, including such exotics as azuki beans, silk, rubber and wool. Energy comprises 44 per cent of the index; agriculturals and softs 32 per cent; metals 21 per cent and livestock 3 per cent.

TAKE IN Commodity Index Comparison

All of these indices are very broad based and include a wide range of underlying commodities futures – they are all composite indices. Many investors prefer a more focused approach - they’re aware for instance that indices like the GSCI are heavily biased towards energy based products. That’s been great over the last few years as the price of crude oil has doubled, dragging up heating oil and gas prices in its wake. But it makes many investors nervous about effectively betting their investment on geo-political risk, the proclivities of the Saudis and the huge debate raging over whether there’s such a thing as peak oil. Some investors may want to buy exposure to commodities but want to exclude energy related commodities – the index developers have anticipated this and developed a layering of sub-indices that group commodities into energy and non-energy components or baskets. These basket indices tend to break down into four main sub groups -

•Energy commodities

•Agriculturals broken into softs and hards plus livestock

•Industrial metals including copper and nickel

•Precious Metals

Beyond these baskets of commodities, you’re into individual indices that track a specific commodity – these tend to be the territory of professional investors with specialist knowledge and are best avoided by most private investors.