How do you calculate the average performance of a stock market?
This is a harder question to answer than it may at first seem. For example, the FTSE 100 Index is a measure of the aggregate market capitalisation of the 100 companies in the index. The problem is that the index is greatly influenced by the larger companies in it (the five largest companies in the index account for 27% of the total market capitalisation, while the 21 smallest companies in the index account for only 5% of total capitalisation).
So, how representative is the FTSE 100 Index of the average performance of the 100 component companies?
In the following chart the bars shows the proportion of FTSE 100 companies that out-performed the index in each year for the period 2005-2015, and for reference the line plots the index value. For example, in 2005 55% of the FTSE 100 companies out-performed the index.
As can be seen there is quite a range of annual behaviour here: in 2007 46% of companies out-performed the index, while in 2012, 77% of companies out-performed. In other words, tracking the FTSE 100 Index in 2012 resulted in under-performing 77% of the individual stock performance. In only year, 2007, less than 50% of stock out-performed the index.
For comparison the following is a similar chart to that above, but this time for the FTSE 250 Index.
As can be seen, for the mid-cap index the variability of the proportion of out-performers is far less than for the large-cap index, and the years of individual companies out and under-performance are evenly matched.
A reason for this is that size disparity is greater within the FTSE 100 than the FTSE 250: in the former the largest company has a market capitalisation 47 times greater than the smallest company in the index, the equivalent figure for the FTSE 250 is 10 times.
In 2015 the indexing company FTSE Russell introduced a new index to address this. The index is called the FTSE 100 Semi Annual Equally Weighted Index, and each of the 100 companies in the index is given a weight of 1% (that is re-balanced every six months).
NB. Deutsche Bank launched an ETF tracking this index, ticker: XFEW).
Such an index is sometimes called a price-weighted index. Before the age of computers it was common to calculate stock indices this way. For example, the FT 30, Dow Jones Industrial Average, and Nikkei 225 were (or are still) price-weighted indices.
If an investor believes that larger stocks will underperform smaller stocks for a period, then switching out of a traditional market-cap weighted tracker (such as a FTSE 100 ETF) into an equally-weighted tracker may make sense.