The Rationale of Equity Indexation - Essay Example

Capital market transactions are deemed efficient in the absence of intermediaries except for brokers who put buyers and sellers together and get a small commission, making the deal almost frictionless. With transaction costs negligible, the only real factor that determines the current price of a stock should be the net present value of its future cash flows in the form of dividends and, assuming the company lasts long enough, capital gains when the stock is sold at a future date. After all, a stock is nothing else but a claim to a company's future cash flows, and that its price indicates its net present value given the amount of cash it would generate over a future period of time (Graham, 1984).

A company's cash flow is affected by several factors, such as business prospects, management quality, the economy's over-all performance, and the company's past performance. If these sets of information are known, computing for free cash flow looks relatively straightforward, and using a discount rate, the stock's present value can be easily calculated. If the market price is lower than the present value, the stock is bought. Otherwise, if one is holding the stock, it is sold. The low transaction costs of capital markets.

"Beating the market" means that an investor cannot generate a rate of return from investing in the equities market that is above the rate of return of the whole market. The rate of return of the whole market is measured by looking at the rates of return of a basket of equities that is representative of the whole market of equities. This basket consists of stocks of companies of different sizes and from different industry sectors from amongst the list of all companies traded in the capital market, say in the London Stock Exchange.

Using a formula that takes into account market capitalisation, historical share prices, and other considerations, the financial authorities determine which stocks to include. The stock prices of these stocks in the basket are mathematically added up to come up with the index that reflects the behaviour of the market as a whole. There are several indices formulated for the London Stock Exchange by an indexing company called FTSE International Ltd., an affiliate of the Financial Times Ltd., a U.K.-based firm.

Amongst the indices monitored by FTSE are the FTSE All-shares (688 stocks), FTSE 100 (102 stocks), FTSE 250 (250 stocks), and the FTSE SmallCap (336 stocks) indices (FTSE ASWB, 2005). At the end of each trading day, FTSE adds the prices of the stocks in each of these indices and then publishes the results.Under the assumption that the market is efficient and that it is not possible to beat the markets, an investor can decide to adopt an equity index strategy, which consists of buying a basket of stocks in the same proportion as they are included in the basket of stocks used to calculate an index.

Several fund management firms have made the job of investing easier by developing funds that