This article appeared in the April 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Understand what a sharemarket index is and how it can help.
By David M. Blitzer, S&P
The first questions any share investor asks are, 'Is the market up or down?' and 'How are my shares doing?'. The answers to these and many other questions about the market depend on having a good sharemarket index. It measures the market and tells you if it's up, down, ahead or behind. But what is an index?
A share index is a collection of shares chosen to represent the overall Australian sharemarket and compiled to give important statistics about the market and investment results. Some indices are used to develop investment products, such as exchange traded funds (ETFs).
It is also important to understand what an index is not. It is not investment advice and it is not a representation about investing in particular shares, mutual funds, exchange traded funds or other financial products. Investors are encouraged to seek independent investment advice before making investment decisions and consider their own financial objectives, situation and needs.
Best measure of the market
The most widely followed indices for Australia's sharemarket are the S&P/ASX indices. These are maintained by S&P Indices with the co-operation of ASX. S&P Indices is a leading global index provider that publishes indices for more than 80 markets around the world. Based in the United States, with an office in Sydney, S&P Indices is best known for the S&P 500 covering US sharemarkets.
The lead index on ASX is the S&P/ASX 200. For many investors it is Australia's equivalent to the S&P 500 in the US. The 200 is part of the S&P/ASX index series.
For investors to see how the S&P/ASX 200 can help them, they need to understand how the index is constructed. It includes the 200 largest and most liquid shares traded on ASX and represents about 80 per cent of the total value of all shares traded.
The index is float-adjusted, market cap weighted. That means, first, the index represents the shares of each company that are available to investors; and, second, that the weight of each share in the index depends on its value compared to the value of all the shares in the index.
By constructing the index this way, measurements based on the index give the best measure of the market. In particular, the return or performance - the percentage increase or decrease in the index over a period of time - is also the measure for the market. If you want to check the market you can view the ASX index charts page, or a newspaper for how the S&P/ASX 200 did today, this week or so far this year.
The index can tell us a lot more about the market. With recent gyrations in oil prices and the consequences of the earthquake in Japan, we hear a lot about sharemarket turmoil. Wondering what the biggest fall the market has suffered in 10 years? A look at the history of the S&P/ASX 200 can answer that. In fact, almost any question about market statistics can be answered with a good index such as the S&P/ASX 200.
Here is a chart of the S&P/ASX index over 10 years. (Editor's note: The red line is the accumulation index, which includes reinvestment of dividends. The blue line reflects share price changes of companies in the index.)
Chart of the S&P/ASX index over 10 years
Differences between indices
Before using the S&P/ASX 200 we need to understand the difference between a price index and an accumulation index. Most information published day-to-day about the S&P/ASX 200 reflects share price change but does not include dividends paid. This is called price performance and is based on a price index. When dividends are included, usually over periods of a month or longer, the measure is called an accumulation, or total return, index.
If you open the newspaper one morning and see one of your shares rose 3 per cent the previous day, and you want to see if a big market gain pushed them up or if it was news about the company, check what the S&P/ASX 200 did. If the index was off 0.5 per cent, your shares jumped because of some company news or a rumour.
Perhaps you do not check the shares news every day but once a month check your superannuation plan. Comparing how your share investments do against the market is one way to evaluate your plan. You probably need to look at the accumulation index, but make sure your superannuation and the S&P/ASX 200 are both either price indices or accumulation indices.
One more measure may be useful for checking your investments. We all want shares to gain, but most also want smooth, placid movements instead of huge swings up and down. A statistical measure called volatility gives an idea of how jumpy the market or a portfolio may be.
Suppose you compare two possible investment plans for your self-managed superannuation fund and both have roughly the same returns over the past few years. One has a volatility of 25 per cent and the other 15 per cent. This means the 15 per cent volatility is less bumpy - and possibly less worrisome - than the plan with 25 per cent volatility. You can see how bumpy the market is by looking at the volatility of the S&P/ASX 200 over the same time.
Take a look inside
Another way to use the S&P/ASX 200 to understand the market's movements is to look inside the index. There are 200 shares, too many to look at one by one. However, all the shares are categorised into one of 10 sectors - such as financials, consumer staples, industrials, materials, and so forth. There is an index for each sector.
Wondering what drove the market up last year? Look at the sectors and see which ones rose or fell. We have only scratched the surface of what can be done with the S&P/ASX 200. If you want to look deeper, try the website of S&P Indices and the ASX website.
A whole other aspect of indices, including the S&P/ASX 200, definitely deserves mention. There are investments that track the index - funds that hold the shares in the index in the same proportions as the index and are known as index funds. There are mutual funds and exchange traded funds tracking different indices, including the S&P/ASX 200.
The returns - both price and accumulation - for a fund that tracks the index may not exactly match the index because there are usually investment management fees and other expenses. Also, some managers may deviate slightly from the index and, at times, this may result in higher returns for the fund compared to the index. This is known as optimisation.
However, if an investor is looking at a fund that tracks an index and another that makes no effort to match the index, the tracker will have results much closer to the index.
Why choose a fund that tracks an index? One reason is that it is easy to see how you are doing; looking at the index should give a very good idea of where your fund is. A more important result is that index-tracking funds often outperform similar actively managed funds, as is often the case within the Australian market.
The reason has little to do with the quality of managers or the index and everything to do with costs and fees. Because a fund that tracks an index does not have the expense of shares research and selection - the index provides all the share selection required - expenses and fees tend to be much lower. One of the best ways to save money and boost investment returns is to pay lower fees.
S&P Indices publishes a report comparing indices and active funds and showing how these comparisons can be made.
Indices are the key to understanding the sharemarket, and the S&P/ASX 200 is the key to understanding what is happening on ASX. A good place to start is ASX and S&P Indices, which offer background on indices and the markets.
About the author
David M. Blitzer is Managing Director, and chairman of the Index Committee, S&P
Indices on the ASX website provides more information about the benefits of trading index-based investments, and key features of indices. It also outlines the four main types of indices:
- Capitalisation indices
- Sector indices
- Strategy indices
- Volatility indices.
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