Why indices can distort the picture

Thanks to HSBC, even retail investors can now buy a derivative instrument which exactly mirrors the performance of the FTSE100. So much easier than buying the underlying stocks. But is the FTSE100 the type of index anyone would want to track? The quarterly reshuffle of the FTSE100 constituents on Monday, which saw three financial stocks enter the top flight while just one financial was pushed out, has continued a trend that has been reducing the apparent meaning of the index for some while now. Boosted by the summer's wave of demutualisations, the benchmark index has become as much a measure of the health of the financial, oils and pharmaceuticals sectors as the market as a whole.

That has led to some misleading distortions. Over the past year, the FTSE100 has risen by 28 per cent, giving rise to the superficial impression that we are experiencing a stock market boom. It hardly feels that way in the second and lower divisions, where the FTSE250 index of companies with a bias to manufacturing and exports has risen by just 7 per cent and the Small Cap has increased by only 5.5 per cent.

It is little wonder that directors of smaller companies are buying shares in their own businesses at a faster rate than at any time since 1992, when sky high interest rates had depressed shares to silly levels. Despite the feeling that a crash is just around the corner, those closest to the action believe there is still plenty of value in the market.

Here are just a few of the distortions that exist in the FTSE100. Banks, which account for less than 10 per cent of national output, represent more than 20 per cent of the capitalisation of the FTSE100. Furthermore, half the earnings of the index's companies are made overseas. Factors such as domestic interest rates are becoming less and less relevant to its progress, and manufacturing is disappearing from view in stock market terms.

One way of dealing with the problem would be a return to a more subjective measure, such as the old unweighted FT30 basket of stocks, which was chosen with the express aim of giving a representative snapshot of the market as a whole. That would be a mistake.

For all its faults, the FTSE100 does represent a totally objective measure of the country's biggest stocks. It also represents around 70 per cent of the capitalisation of the market as a whole, which gives it a certain significance even if it does not tell the whole story. For that, investors will have to continue looking beyond the headlines to the full range of indices.