The performance of an investment may be an investor’s main consideration to determine its success. However, it’s also important to measure how it stacks up against a relevant benchmark, often known as an index. If you’re a novice investor, it may be very beneficial to have a good knowledge of an index.
What is an index?
An index is a measure or indicator of something. In the investment world, it generally refers to a measurement of change in the financial market. Essentially, it measures the performance of an investment against listed securities or a specific industry.
It should be understood that indices are comprised of a hypothetical portfolio that represents a subgroup of the market – you can’t invest directly in an index. In South Africa, the Johannesburg Stock Exchange (JSE), FTSE/JSE All Share Index (ALSI) and Top 40 are prominent indexes.
Just like investments, no two indexes are the same. There are nearly 100 indexes in South Africa which means that investors can have a comprehensive overview of the performance of different industries.
As mentioned above, you can’t invest in an index, but investors’ can try to match their performance as accurately as possible – this is known as passive investing. Approaches to this type of investing include holding identical shares with equal weighting as the index that you choose.
Concentration
It’s vital to understand concentration because it can skew the performance of stocks in an index. Basically, if a stock has a higher weighting in an index, it’s performance can tilt towards the performance of the stock.
For example, Naspers makes up 20.35% of the ALSI. This means that fluctuations in the price of Tencent – a multinational entertainment and technology holding company (in which Naspers has a majority shareholding) can skew the performance of the ALSI.
To even out the slant, the FTSE/JSE Capped Swix All Share Index was introduced. This has aided the necessity of having a fair index that proportionately characterises the market.
It’s also important to note that an index can influence the stock of which it is comprised. The following example can help give you a better understanding of the principle. When a certain stock is added to a major index, the share price can potentially increase. The reason for this is that its inclusion as a prominent index can impact demand for that specific stock, which can drive up the unit trust prices.
Selecting an index
Here’s the crux of the matter. An investor should select an index that has an appropriate benchmark aligning with his/her financial objectives as well as restrictions of his/her portfolio.
An excellent example of an inappropriate benchmark is comparing a unit trust that is mostly invested in equities to the performance of a bank savings unit trust. Why? Because the risk of taking on equities is much higher than the risk of bank savings.
If all of this information is daunting, it’s worth speaking to an independent financial advisor. He/she has the knowledge to explain and advise, on which indexes align with your financial goals.