Tuesday, 28 July 2009

Using Indices to Benchmark Your Investment Results

Once you have investments, you probably, or should, want to know how they are doing. A natural first check is simply to look at an account statement and see if the investments are up or down. Next might be a comparison to the rate of inflation at the Bank of Canada to see if you have gained or lost in real terms.

Markets as a Benchmark
A third measure is to compare against how everyone else is doing, in other words against the market. Doing better than the market - out-performance - is a more severe test of success. For example, if your investments went up 8%, that might seem quite good. However, if the overall market went up 12% then you are 4% short of the average, not so good. Conversely, in 2008 stock markets everywhere were significantly down, anywhere from 30 to 45%, so if your investments only went down 10%, that was great performance!

What is a Market Index?
A market index, such as the TSX, the Nasdaq or the S&P quantifies the rise or fall of a collection of stocks, which may represent a market like the TSX. The S&P / TSX Composite includes the largest and frequently traded companies traded on the Toronto Stock Exchange (TSX), currently 208 companies, which represent about 95% of the total value of Canadian equities. Or an index might represent a mixture of government and corporate bonds or other securities.

There are thousands of indices worldwide for stocks, bonds, commodities, real estate, industry sectors, regions, investing styles. Which securities are in an index and in what proportions can have big effects on performance numbers, so it is important to pick appropriate indices to really compare your apples with other apples and not with oranges or chimpanzees.

With that in mind, this post sticks to basics and commonly-accepted theory to suggest some principles and a list of indices for a Canadian individual investor.

Principles for Choosing Indices
  • Asset classes for boundaries - assumes that you the investor look at your securities as a portfolio - an integrated whole diversified among asset classes; results in choosing broad indices and keeps the number down, thus easier to manage tracking
  • Market capitalization weighting - presumes that the "market knows best" so that big companies are big in the index even if it seems out of line at times; avoids fundamental indicator selection and/or weighting, capped-weighting (a limit on how much of the index one company is allowed, going back to the tech bubble when Nortel made up 40% of the TSX at one point)
  • Total return - incorporates dividends as opposed to price movements only since a dividend is real money in the account
  • Canadian dollar (CAD) conversion - unless you plan to keep and spend the investment return in US dollars (USD) or whatever other foreign currency, then the value expressed in Canadian funds is the right yardstick and we know that currency swings can be dramatic, pushing returns either up or down. For the ones below that don't give values in CAD, go to the Bank of Canada currency converter for the beginning and end date USD-CAD rates
The Indices

1) Equity2) Bonds
3) Real Estate
4) Commodities


thecouchpotatoblog said...

Hasn't market capitalization weighting been one of the leading causes of the current recession? By putting our faith in the big companies including banks, we have let our economy crumble. Would you advocate this method?

CanadianInvestor said...

Market cap weighting is too small to have any influence on markets. The number of investors who actually buy according to market cap weighting through passive index funds is still a very small proportion (under 10%) of the total funds market. Actively managed mutual funds still own the vast majority of assets. Market cap weighting only contributes to excesses in a very minor way by following along with the active investment crowd.

I generally advocate the passive approach for everyone who doesn't want to, or cannot, devote time and attention to monitoring individual stocks/companies.

I really don't think it is large companies that are more or less culpable of risky economy-crumbling behaviour, it's just that when a giant falls, everyone knows and feels it. Also, look at our large Canadian banks - their cautious behaviour has kept them free of government rescue, unlike many foreign banks.