Jeremy Warner's Outlook: New-wave stock market indices may be good for your wealth

The end of the motor car? Not quite yet; Amaranth: the dangers of leverage
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The Independent Online

There's been growing interest in alternative stock market indices since The Independent launched the Indy 100 last February. I don't pretend to have sparked this trend, but we were in its vanguard. Now others are joining the crowd. FTSE and Nasdaq have both been working on indices which promise to reflect more accurately the fundamentals of the companies they represent, rather than their values.

Traditionally, stock market indices have fallen into two distinct categories. Some of the oldest, such as the Dow Jones Industrial Average, are at root mere averaging exercises, where the share prices are added up and divided by the number of shares in the index. Simple, but relatively effective. Supporters of the Dow still claim that it more accurately reflects the real performance of industrial America than anything else that's around.

The other type of index, epitomised by the FTSE 100 and the S & P 500, instead weights constituents according to relative market value, so that, for instance, movement in the share prices of really big companies such as BP and Vodafone are given a lot more value in the index than those of smaller ones. A relatively small movement in the price of BP may thus affect the index more than a large movement in a smaller stock.

The advantage of the weighted approach is that it reflects more accurately than anything else what's happening to the total, aggregated value of the stock market. It's easily measured, and nobody can have any argument with what it is trying to do. Most tracking by passively invested funds is done against these indices. Yet despite the simplicity of the method, there is widespread agreement that weighting against stock market value may not serve investors terribly well.

This is largely because of the vagaries of investment fashion, highlighted in spectacular manner by the dot.com boom, which saw technology, internet, media and telecom companies, many of them of little underlying substance and of even more questionable prospects, soar to spectacular valuations. The subsequent destruction of value when the scales finally fell from everyone's eyes was equally dramatic. This speculative boom and the subsequent bust was magnified in the weighted indices.

Strip out these sectors and, in fact, there was no bear market at all in the 2000-2003 period, but just a continuation of past progress. The same result is achieved by weighting all the constituents of the FTSE 100 equally. By holding all the constituents in equal measure, you would not have experienced the peaks the market rose to at the turn of the century, but nor would you have experienced the subsequent trough.

It was this sort of thinking which instructed the formation of the Indy 100. In our index, each stock is weighted equally and then rebased to one at the end of each day to prevent a weighting bias building up over time.

The other purpose of the index was to make it more reflective of the UK economy than the FTSE 100, which is progressively stocked by big international companies, many of which derive some, most or all of their earnings from abroad. As expected, we have already outperformed the FTSE 100 by a considerable margin. Since its inception in February, the Indy 100 is up nearly 9 per cent, against just 2 per cent for the FTSE 100.

The new indices being devised by FTSE use a still different approach. In these indices, companies are to be weighted according to their fundamentals - assets, cash flows, sales, and so on. Again, the vagaries of investment fashion, where glamour stocks gain high valuations, ought to be ironed out.

All indices have their drawbacks. The problem with the Indy 100 as it stands is that it is virtually impossible to track. We are working on this design fault. With the fundamental indices, it is the fact that the weightings are based on inexact information which will deter. They are also very much a part of bear-market thinking, and it seems doubtful they would survive another dot.com boom.

By their nature, indices based on fundamentals are unlikely to deliver returns of any more than the long run trend. When everyone else is making spectacular returns, the temptation to join in may prove impossible to resist. That, in any case, is what happened last time when those who held true to the traditions of "value" investing were punished for their caution by losing their jobs.

The end of the motor car? Not quite yet

The state of California's decision to sue car makers for their contribution to global warming is more political stunt than anything else, but it is also a sign of the times.

Mass car production is coming up for its centenary year - Ford's Model T, the first production line car, went on sale in 1908. One hundred years later, this transforming technology - or at least the original version of it - may already be facing oblivion. I exaggerate, of course, but only to make the point. This is obviously not the end, or even the beginning of the end of the mass-produced car. More than a billion aspiring Chinese and Indian car owners suggest powerfully that auto manufacturing will remain a growth industry for some years yet.

But California's little bit of politicking does, perhaps, mark the end of the beginning. The next phase of development - cleaner, hybrid, and fuel-cell cars - is already upon us. Within ten years, the gas-guzzlers so beloved by American drivers and school-run mothers will be gone - priced and legislated out of existence. Already Ford has had to admit that the business model which has served it so well all these years no longer works.

Of course, it will require the invention of a completely new technology to make the automobile wholly redundant. Voters would still rather destroy the planet than give up their cars altogether. Yet attitudes are changing, and in maturer, developed markets, it is already possible to envisage a time when overall car sales are in precipitous decline.

In Europe, gentle decline is already an established fact, though it is as yet unclear whether this is more of a cyclical than structural phenomenon. In any case, prescriptive action against climate change is likely to hasten the trend. To compensate, public transport will have to be made more extensive and user-friendly. Eventually, new forms of transportation will be invented. There is nothing like necessity to drive innovation. The transport systems of science fiction may not be as far in the future as we think.

Amaranth: the dangers of leverage

The $6bn (£3.2bn) lost by Amaranth Advisers while trading gas contracts has further heightened concern among regulators about the exponential growth of hedge fund and private equity investment. These losses happened on the other side of the Atlantic, and, as far as we know, are relatively contained. Wider systemic damage looks limited.

Even so, it is a mighty big loss to have come tumbling out of a clear blue sky and only goes to show how obfuscated and free of prudential oversight large parts of the financial markets have become. Much of the wheeler-dealing that takes place in the capital markets these days is built on debt. In theory, this ought to mean that regulators get to exercise oversight through banking supervision.

Yet in today's markets, debt is securitised. The effect should be to spread the risk, but it is not clear this is in fact the case. When the going gets tough, the debt tends to come bouncing back on to the securitising bank. This is what happened with Enron, when buyers of the debt claimed they had been sold the stuff on the basis of a false prospectus.

As commerce becomes ever more leveraged with debt through private-equity and hedge-fund ownership, it gets ever harder to know where the risk really lies. It may be a good deal more concentrated than generally understood. The growth of private-equity and hedge-fund investment has enriched a small number of individuals beyond the dreams of avarice. It has also made the world a much more dangerous and untransparent place.

j.warner@independent.co.uk

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