Friday, July 06, 2007

Look Beyond the Index Headlines

This article from Robin Bowerman's weekly Smart Investing newsletter:

Our sharemarket index grabbed the performance headlines this week.

The S&P/ASX 200 index that you see quoted on the television news most nights claimed its best year since it was introduced in 2000. A return for the last financial year of 28.7% shaded the previous best of 26.4% in 2005 according to Jason Hill, director, index services at Standard&Poors.

Short-term performance numbers like those have a tendency to blind people to normal long-term levels of return. And this is where understanding and using indexes can help you keep a realistic perspective - particularly if you are projecting out your superannuation in 20 or 30 years time. For example in the past 10 years ended June 30 the Australian sharemarket index delivered 12.8% return a year - a strong result but more in keeping with long-run averages than the latest series of 20+ per cent returns.
As Vanguard is an index fund specialist this is an area of focus but there for individual investors indexes are great tools to measure your portfolio against.
Some people love data - retired engineers or actuaries for example - while other people find studying numbers about as exciting as watching grass grow.

But whether you are playing sport or investing it is useful to know what the score is. So as we do the financial housekeeping associated with the end of another financial year there is one question every investor ought to be able to answer - how did your portfolio perform?

Professional investors like large super funds track and attribute their performance precisely. They have the resources and expertise to do that but as an individual how do you measure your portfolio - particularly if you have a self-managed super fund and by definition a very individual investment strategy?

It is straightforward for individual investors to set themselves a benchmark to measure their portfolio against. For Australian shares it might be either the S&P/ASX 200 or the broader 300 index while for property trusts it will almost certainly be the S&P/ASX300 Property accumulation index. If you are looking overseas then there is a wide range of indexes but (for example) Vanguard measures its international shares fund against the MSCI World ex-Australia Total Return Index. That excludes our local sharemarket so you can see how the world's major sharemarkets are performing.
The index is a straightforward measure of a market's return - and they can be broad or quite narrow and specific - but the value to an individual investor is an index tells you in an unemotional way whether your portfolio outperformed or underperformed a particular market.

Why is setting benchmarks for your portfolio important? Well consider the case of an investor that a financial planner described recently.

This investor actively trades a significant share portfolio. He works hard at researching and studying companies and at the end of the financial year thought he had done pretty well. So he was taken aback when his accountant/financial planner explained that while the portfolio had indeed done well it underperformed the sharemarket by 3%. And that was before the tax cost of a high turnover portfolio is factored in.

As individuals we are programmed to believe that hard work and extra effort is generally rewarded. So the financial planner who relayed the story above found it a real challenge to get through to their client that all the time and research effort they had put in to managing their portfolio actually detracted value from what the market had delivered and could have been achieved by simply buying the index and using all the time spent monitoring stock performance to do other things.

Other investors may have done better and beaten the market but unless you measure your portfolio against a real world benchmark you simply do not know the score - and whether the effort and cost in transaction fees and tax were repaid.

Investment professionals like researchers and asset consultants use indexes as a critical measure of a fund manager's performance. An individual investor who uses an index correctly will find it is that rarest of commodities - a companion that keeps you honest.

How key indexes have performed to June 30, 2007

Asset class (Index name)
% Performance for 1 year; % Performance for 5 years

Aust shares (S&P/ASX 300 accum)
29.2% ; 19.3%

International shares (MSCI world ex-Aust)
7.7% ; 4.6%

International shares (MSCI world ex-Aust)
(hedged into $A)
23.7% ; 14.3%

Australian property securities (S&P/ASX 300 property accum)
26.3% ; 18.3%

Aust fixed interest (UBS Aust composite bonds)
3.9% ; 5.4%

Intenational fixed interest (Citigroup World Govt Bond)
5.2% ; 6.7%