When evaluating an investment, performance is often top of mind for would-be investors. The next consideration should be how well the investment stacks up against an appropriate benchmark, explains Tebogo Bore.
The performance of an investment is measured against a benchmark, which is often an index. However, less experienced investors don’t understand what indexes are or how they are chosen. An index is a collection of assets that represents a subset of the market and measures performance over time. Think of it as a ruler to measure how well an investment has performed compared to other listed securities or an industry. Prominent international indexes include the S&P 500, the Dow Jones and the FTSE All-World Index. Locally, the Johannesburg Stock Exchange (JSE) Top 40 and the FTSE/JSE All Share Index (ALSI) are well known.
When you think of it, no two investments are identical, and the same applies to indexes. There are almost 100 indexes locally, to give investors a well-rounded perspective of how a section of the market is performing. This means that each index will be nuanced in its construction, ease of access and cost.
You cannot invest in an index, but investors can aim to replicate the performance of one. This style is called passive investing. There are different approaches to passive investing, including holding the same shares, and in equal weighting, as a chosen index. This is different from Allan Gray’s style of active investing, where a bottom-up analysis of companies drives stock allocation.
Just as one person can dominate a conversation, the same can apply to stocks in an index. If one stock has a dominant weighting in an index, the performance of that index can skew to that stock’s performance – this is the case with Naspers, which makes up 20.35% of the ALSI (as at the end of July 2019). Any fluctuations in the price of Tencent, of which Naspers has a majority shareholding, will distort the performance of the ALSI. To curb this, the FTSE/JSE Capped Swix All Share Index was introduced to limit the dominance of dual-listed shares, such as Naspers, in the local indexes. This evened out the playing field and has emphasised the need to have a fair index that proportionately represents the market.
The imminent listing of Naspers’s international assets on the Amsterdam Stock Exchange as a new group called Prosus, is hoped to have a positive impact on the concentration of the local indexes. However, given that Prosus will have a secondary listing on the JSE, the total weight of Naspers (including Prosus) in the ALSI will not change materially. However, Naspers’s overall weight in the capped indices will actually increase since the weights of Naspers and Prosus will be capped individually, instead of collectively as before.
An index can also influence the stocks it comprises. For example, when a stock is added to a prominent index, its share price can increase as a result. This is because inclusion in a notable index impacts, among other things, market demand for that stock which can drive up the price.
Selecting an index
Investors are required to choose an appropriate benchmark for each investment: It must match their investment objectives and portfolio restrictions. This is intuitive: For example, comparing a unit trust that is primarily invested in equities to the performance of bank savings isn’t appropriate, as the risks you take on with equities are much higher than with bank savings.