The global stock market is a vast financial entity, and one that has seen its market capitalisation value soar markedly throughout the digital age.
For example, the sector’s total market cap value was estimated at just $2.5 trillion in 1980, with this having increased to a staggering $93.7 trillion by the end of 2019.
At the heart of this is the market’s immense flexibility, with index trading offering a unique investment vehicle that also measures the state of a particular sector or selection of equities. But what are the pros and cons of index trading? Let’s find out!
What is Index Trading?
Before we delve into the potential advantages and drawbacks of index trading, we need to take a closer look at this practice and how it works.
In simple terms, index trading is an investment method that targets a specific group of stocks and equities. Indexes can target different types of stocks, with groupings based on variable factors such as market capitalisation values, their country of origin and the industry in which they operate.
For example, the famous FTSE100 lists the top 100 companies listed on the London Stock Exchange based on the market cap valuations. Conversely, the tech-heavy Nasdaq-100 index comprises 101 equity securities issued by the largest non-financial companies, while also serving as a modified capitalisation-weighted index.
The FTSE also offers access to a broader range of sectors, from healthcare and tech firms to blue-chip retail stocks such as Sainsburys.
Interestingly, indexes provide a clear measurement of the value of a particular section of the wider stock market, with valuations usually calculated by adding the individual share prices together and then dividing them by a ‘divisor’ (which changes when there are equity splits or a company is added or removed from the index).
There are subtle variations to this rule, of course, and it’s important to research an index and its equities before you invest your hard-earned capital.
What are the Advantages of Index Trading?
Overall, an index of any description will provide a quick and insightful measure of the state of a particular market or economy.
But what primary benefits does this type of trading offer to investors? Here’s an overview of the primary advantages and why they’re so important:
- #1. Gain an Insight Into a Wider Market and Economy: Because indexes create targeted (albeit hypothetical) portfolios of stocks, they’re designed to give an instant indication of a particular market’s performance. In the case of indexes like the FTSE100 and Dax, this type of asset can also offer an insight into the performance of a national economy and macroeconomic factors such as supply and demand. What’s more, it provides a source of historical data that can indicate how markets have reacted to specific circumstances in the past, creating more informed and deterministic trades in the future.
- #2. Take a Consolidated View and Minimise Exposure: When buying and holding individual stocks, you’re exposing your capital to the risk that the underlying asset’s value will depreciate over time. However, as index trading encourages you to analyse and invest in much broader market sectors, you’ll achieve natural diversification while immediately minimising your exposure to risk. This offers a huge advantage in the current economic climate, where rampant inflation and reduced GDP growth continue to weigh heavily on earnings and share values.
- #3. Go Long or Short Depending on the Market: On a similar note, index trading should be considered as a speculative investment vehicle. Because of this, you can trade flexibly and assume both long and short positions on a particular index, depending on whether you expect its value to rise or fall within a specified period of time. With index futures, you can even hedge your risk, which is particularly important during periods of economic uncertainty or short-term bear markets that are temporary in nature.
What About the Drawbacks of Index Trading?
In order to help you to fully evaluate index trading, it’s also important to consider its potential drawbacks and disadvantages. These include:
- #1. Stock Index Calculations Are Far From Being Infallible: On a fundamental level, there are some issues with the calculation of stock indexes. For example, the Dow Jones Industrial Average (DJIA) is a price-weighted index, which is calculated by taking the cumulative price of all 30 listed stocks and dividing this with a divisor. While this is a popular calculation method, it makes no allowance to the relative size of the industry sector of a particular stock or its market capitalisation, creating a potentially false perception of indexes’ short, medium and long-term value.
- #2. A Lack of Exposure to Small-Cap Companies (in Some Cases): Conversely, the S&P 500 is a market cap-weighted index that provides a disproportionate weight to bigger, large-cap equities. As a result, the index is overly influenced by the price of a select few stocks (such as Apple and Microsoft), creating a similarly disproportionate outlook among investors. On another note, many indexes of this type fail to provide exposure to small-cap and high-growth firms, which historically have tended to produce much higher returns over time.
- #3. There’s No Control of Index Composition: While stock market indexes can change over time (through stock splits or the removal or addition of equities), investors have absolutely no say or control over composition. In theory, this creates a restricted range of options for investors to consider, and this may provide a deterrent for experienced traders who want to assume more responsibility for their portfolios. It’s also interesting to note that by definition, indexes are unable to beat the market, creating a potential downside for ambitious and risk-hungry investors.
The Last Word
Ultimately, index trading is a popular vehicle that offers significant value to investors, particularly in terms of the flexibility that they provide and the way in which they’ve made the stock market more accessible.
However, there are both pros and cons associated with index trading, and it’s important to consider these in detail before determining the role that this type of investment should play in your portfolio.
It’s also important to understand that not all indexes have been created equal, either in terms of their composition or the level of insight that they offer to investors.
