Last week I looked at index construction and explained how some of the popular indices in the world are constructed. Now I will look at how they can be used for comparative purposes. An important concept when analysing indices is proportionate or percentage change in the value of the index.
If I want to know how much prices have increased by in Guyana over the last ten years or so, I can take the latest value of the retail price index of 192.7 at the end of August 2004 and divide it by the value at the end of December 1993, when the value was 100. This gives 1.927 which means that on average consumer goods and services cost 1.927 times than they did 10 years and 8 months ago.
The percentage increase in prices is 92.7% so putting this into words prices have increased by 92.7% in over that time period.
For those financial indices weighted by market capitalisation the percentage increase in the index is the return which would be obtained from holding a portfolio of the same assets that make up the index. The return is the amount of money which would be made if the assets were bought at the start of the period and sold at the end of the period expressed as percentage of what was first invested. Most indices are capital return indices; that is they do not include the returns on dividends. A total return index allows for dividend income and its reinvestment and the return on this index can be directly compared with the return on a savings account which is quite simple to calculate as it is equivalent to the rate of interest paid.
Working out the return for different countries' stock markets makes it readily apparent which one has performed the best.
Benchmarking is the process of assessing the return of a particular portfolio relative to the benchmark, which may be a published index or one specifically created having regard to the particular characteristics of the portfolio. If someone told you their Guyanese denominated portfolio had returned 10% for 2003 how would you know if this is good or bad? A quick check of the Standard & Poor's 500 total return index measured in Guyana dollar terms would reveal a return of just over 30%, which makes the 10% seem rather lame. However, when compared with the return on savings account at 4% (before withholding tax) or inflation at 5%, then 10% seems quite acceptable.
Obviously you would need to know the kind of investments that are in your friend's portfolio to know which of these measures you should need to compare with. For me a basic benchmark I always consider is inflation: provided your savings are increasing in value by more than inflation they are growing in real terms.
Benchmarking is becoming particularly relevant for mutual funds as competition from passively managed funds (sometimes called index tracking funds) increases. Unlike active fund management, where the manager buys stocks they think are overvalued and sells stocks they think are undervalued in order to try to increase the return on the portfolio, the passive fund manager has one goal, to keep their portfolio as closely aligned to the index as possible. This means that the return achieved will almost always be close to the return on the benchmark index (before the deduction of charges).
Since the charges on active funds are generally higher than those on passively managed funds, it is important for active managers to demonstrate they are adding value, thus outperforming the benchmark becomes of paramount importance.
Even without calculating returns indices are very useful to show how different investments have performed. Because indices can be arbitrarily scaled it is easy to plot them side by side along to the cost of living. The visual aspect can be striking - below I show the returns on the Standard & Poor's 500 index (with income reinvested) in G$ terms versus inflation as represented by the Georgetown urban consumer price index (or CPI for short) and the roll up of a deposit account to which the small savings rate applies (1970 = 1).
Small Savings versus US$ shares and inflation in G$ terms
As the graph shows, over the last 30 years or so prices have increased some 265 fold while a savings account would only have increased around 24 fold. So an amount deposited in a savings account with the bank in 1970 would buy at best only one tenth today what it could have bought then. The actual amount would be lower as withholding tax would have been deducted.) The investment in the US stock market would have handsomely beaten inflation, thanks in part to the great Bull Run of the 90s and also due to the appreciation of the US dollar when the Guyanese currency was devalued. For each Guyana dollar at the end of 1970 invested in the US stock market there would now be G$3,547 or an annual compounded rate of 28.1% - not bad going!
Over the last 12 years or so, a deposit in a savings account at the end of 1991 would have initially outperformed US equities up to 1995, and over the period has beaten inflation. However, even allowing for the poor returns of 2001, 2002 and 2003 converting the Guyana dollars into US$ and investing them in the US$ market would have provided the greatest return (1992 = 100). Again all returns are before tax.
The final chart shows only capital returns, and compares the capital returns in Guyana dollars stock markets of the UK and US with those in Guyana since our stock exchange began (June 2003 =1000).
It looks as if Guyanese shares have just managed to outperform cash but not the other markets. However, consideration must be given to the fact that the initial dividend yield on the vBI was much higher than the S&P500 or the FTSE, so the difference in total returns would not be as marked since dividend income would make up a greater proportion of the returns in Guyana than the other markets.
(All exchange rates used to convert in the above charts are mid-market rates as published by the Bank of Guyana. For US Dollars this is the transaction exchange rate and for Pounds Sterling it is the market exchange rate. August to September exchange rate data has been estimated based on July figure.)