What is a Stock Market Index?

If you were asked to think of words or phrases relating to the UK stock markets, one that crops up many times is the term FTSE 100. The FTSE 100 is a stock market index; an index is a number that is designed to represent and track the value of something. So while you may have a housing market index to track house prices, there are also numerous stock market indexes that track share prices of companies. A stock market index is an easy way of describing the overall movements of the companies that it is tracking, and if the index is large enough, the general direction of the market.

Types of Index

The purpose of an index is to track a particular part of the market or the overall movement of the market. Numerous indexes exist and are usually linked to a particular stock market; three examples are listed below:

FTSE 250 = Index for the #101 -> #350 largest listed companies in the UK. The index includes  Halfords and Greggs
Dow Jones Industrial Average = Index for the top 30 largest US companies. The index includes Boeing and Goldman Sachs
CAC 40 = Index for the top 40 largest, listed French companies. The index includes Airbus and Renault

Indexes are usually weighted in a particular way; in other words, some of the companies within the index account for a larger proportion of the index movements than others. Most indexes are market capitalisation weighted, where the largest companies by market cap account for a greater percentage of the total index. On the other hand. an index may be share price weighted, such as the Dow Jones.

The FTSE 100

The FTSE 100 is an index tracking the top 100 largest UK listed companies, by market capitalisation, including HSBC, BP, National Grid and Rolls-Royce.

- Although 100 companies are represented, there are actually 102 constituent listings. This is because Royal Dutch Shell and Schroders each have two classes of shares.

-  The index is weighted by 'free float' market capitalisation. The free float refers to the percentage of the total shares in issue that are not held by company directors or company founders; it is those shares that are considered liquid and readily traded.

- The top 5 largest companies account for around 25% of the total FTSE100 index (HSBC, Royal Dutch Shell, BP, GlaxoSmithKline and British American Tobacco). This is because these companies have particularly high market capitalisations. For example, HSBC has a market cap of £116 billion against the average FTSE 100 market cap between £15 billion and £20 billion. Consequently, a fall in HSBC would move the index more than a fall in a smaller constituent such as Next PLC.

-  Index constituents are updated quarterly. The rearrangement involves the smallest FTSE 100 stocks, and the largest FTSE 250 stocks and the purpose is to identify whether any stocks in the FTSE 250 have become larger than the smallest stocks in the FTSE 100 and to replace them. A FTSE 250 company is promoted to the FTSE 100 if its market cap rises to 90th or above in the FTSE 100 list of companies. A company is relegated from the FTSE 100 if its market cap falls to 111th or below in the FTSE 100 + FTSE 250 list of companies.

- A Fast Track Entry rule exists. This states that a company may gain immediate entry into the FTSE 100 if it has a market cap worth at least 1% of the FTSE All Share Index market cap on the first day of trading. The total FTSE All Share Index market cap is currently around £2.1 trillion, so a market cap of £21 billion is necessary to gain the fast track entry. Glencore entered through this route in 2011.

- Since the company composition of the FTSE 100 changes, so does the sector composition. Over the past ten years there has been an increasing proportion of natural resource companies. At present, Oil & Gas, Personal & Household Goods, and Banks are the largest sectors, each representing about 10% of the index.