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By Sheldon Slabbert, CMC Markets
When people talk about ‘the markets’ they are generally referring to an index. A market index is a group of several stocks whose movements are measured together and expressed as an index.
The best-known index is the Dow Jones Industrial Average, usually just called the Dow. The Dow contains 30 of the largest companies in the US and includes household names such as Disney, Microsoft and Nike.
Indices are traded on stock exchanges. The NYSE and Nasdaq are the world’s largest exchanges, representing more than 40 per cent of the total World Federation of Exchanges (WFE) capital.
The New Zealand Stock Exchange (NZX) is relatively small in comparison, with a total market capitalisation of NZ$118 billion on the NZX Main Board of listed companies. In terms of size, our stock exchange represents just 0.12 per cent of WFE-listed companies. New Zealand’s share reflects our small population.
The benefits of buying indices
Investment legends Warren Buffett, of Berkshire Hathaway, and Vanguard Group’s John Bogle are in favour of investing in index-tracking funds. These funds are ‘passive’ investments, where you invest your money and leave it untouched for long periods, rather than actively buying and selling shares.
Buffett’s advice for smaller investors in particular is to put their money into index-tracking funds. He recommends this because these funds help you diversify and cost less than ‘actively’ trading.
“A very low-cost index is going to beat a majority of the amateur-managed money, or even often professionally managed money,” Buffett says.
Investing or trading indices widens the scope of asset classes – groups of similar investment types – you can access overseas, rather than investing purely in your home country. It’s also cheaper to buy an index than to buy individual stocks.
Index funds give you greater flexibility, which is an important advantage. Investors can adjust their portfolios to match current and future economic conditions.
You will not be limited to a single direction, regardless of what the market is doing. Nor will you have to wait for poor-performing shares in an asset class to improve.
Most indices offer the investor the advantage of buying ‘long’ (in the anticipation that their value will appreciate with time). However, they also enable you to sell (should your outlook change) and benefit even if the overall market falls.
Indices also help you to diversify within your portfolio and give you access to some of the world’s biggest listed companies.
The popularity of investing in an index has seen the variety of indices expand, to include different asset classes and countries.
Today, investors can get access to a wide range of asset classes – equities, commodities, metals, real estate, and bonds – simply by buying or selling the related index on exchanges around the world.
How global indices perform
Figure 1 shows how our local share market, as measured by the NZX 50, has performed over the past 10 years. The New Zealand market has been one of the strong performers globally, up more than 7 per cent this year to date, compared to
the S&P 500, which was up only 1.05 per cent as at
30 April this year.
The local market reached its low point of 2,522 in 2009, as did other world markets. It has since more than doubled to stand above 6,800 today.
It’s important to note that the NZX 50 is a gross index, which means that cash dividends are included when its returns are calculated, while other global indices track share price movements only.
Figure 2 shows the performance over the past 30 years of the MSCI EAFE index (orange) which tracks the performance of a group of shares selected from developed countries, excluding the US and Canada.
This index is widely used as a benchmark for the total international stock market. It’s compared to the performance of world’s largest economy, the US, through the US S&P 500 Index (black).
Over the past 30 years, the tech revolution and China have led much of the expansion, but there have also been some notable market shocks along the way.
How do Kiwi investors gain access to indices?
Living in a globalised and connected world means that it’s easy to get access to these markets. Here are three different ways.
1. Index funds: These are a type of mutual fund, with a portfolio constructed to match or track the components of a market index.
2. Exchange traded funds (ETFs): These are investment funds traded on stock exchanges, similar to a form of index fund.
3. Futures and CFD (contracts for difference): These are forms of trading based on a contract between two parties. These enable you to make a profit or loss by speculating on the rise and fall of an asset.
How can I, as an individual, gain access to index funds, CFDs, and ETFs?
A local broker can help you gain access to index funds, and government websites such as Sorted.org are also useful starting points. It’s important to consider how much fees will cost you. Passively tracking an index over time will allow compound interest to work in your favour.
You can also trade various indices, from stocks to commodities, from a single account through futures and CFD providers.
What are the risks?
Apart from the main investment risks of buying too high or selling too low, investors also need to consider currency risks, transaction costs, and performance fees.
As Tony Robbins points out in his most recent book Money: Master The Game, even a seemingly negligible 1 or 2 per cent difference in costs can greatly skew the overall performance of your investment over time.
It’s worth noting that you can only reduce some of the associated risks, but you’ll still have the overall market to contend with. As managed fund legend John Bogle says, “Index funds eliminate the risks of individual stocks, market sectors, and manager selection. Only stock market risk remains.”
The global economic outlook is a hotly debated topic and growth continues to be sluggish. The International Monetary Fund recently revised growth forecasts down to 3.4 per cent in 2016. Many of the largest world economies have negative interest rates and export-dependent countries are facing difficulties selling commodities.
It’s now been seven years since the market low in 2009, and the search for yield and consistent returns will continue for all investors. But many ‘passive’ index fund investors will be relieved that the S&P 500 has had an annualised gain of 7.4 per cent over the past 30 years (excluding dividends), despite many periods of uncertainty.
S&P 500: The S&P 500 Index includes 500 leading companies listed in the US and holds about 80 per cent of the market’s capital.
NZ 50G: The New Zealand Exchange 50 Gross Index consists of the top 50 companies by free float-adjusted market capitalisation.