Market Indexes and index investing

In line with SharePHIL’s advocacy of investor education, we publish relevant articles in this column and also organize seminars on topics of interest to our stakeholders. While indices may seem complex and too technical for the ordinary layman like me, there are practical reasons why investors should have an understanding of these measures which I will attempt to share in this article.

Market index foundations

In a two-part article by SharePHIL vice chair Ed Francisco, president of BDO Capital, he explained the foundations of investment indices. Stock or equity indices are composed of stocks that meet certain criteria over a specified period, These indices track the change in value of the stocks covered. He also wrote about different type of indices that are weighted using different factors as: Market-weighted indices, considered the most common and are calculated based on the total market capitalization of the constituent companies; Price-weighted indices, which are calculated based on the stock prices of the constituent companies; and lastly, Equal-weighted indices where constituent companies are equally weighted regardless of market capitalization or stock price. Other indices track asset classes, such as bonds and commodities.

Stock indices that cover Philippine companies are led by those from the Philippine Stock Exchange (PSE) and Morgan Stanley Capital International (MSCI). For a better understanding of these indices, SharePHIL organized an event on the Effects of Index Rebalancing where representatives from the PSE spoke about the local indices and MSCI presented the basis of their indices.

Advantages / disadvantages of indexes

For small investors who have limited access to complex and sophisticated analytical tools and market research, an index provides a quick measure of the state of a market and it is an easy way to track their portfolio’s overall health. Further, the historical data of index movements and prices can provide some guidance to investors as to how the markets have reacted to specific situations in the past that can help investors make better decisions. Many traders, investors, and other market participants use the performance of indices to benchmark their investments in the stock market.

However, there are also issues with the calculation of stock indices. For example, the Dow Jones Industrial Average is a price-weighted index that is calculated by taking the sum of the prices of all 30 stocks in the index and adjusted based on stock splits, spinoffs, or other changes in the market. Stocks with higher prices have a larger impact on movements in the index compared to lower-priced stocks. As a price-weighted index, no consideration is given to the relative size of the industry sector of the stock or its market capitalization. Another criticism of the DJIA is that it represents a thin slice of the blue-chop universe since it contains only 30 companies.

On the other hand, the S&P 500 is a market-cap-weighted index that is calculated by taking the adjusted market capitalization of all the stocks in the index and then dividing it by a divisor. The main drawback to the S&P 500 is that the index gives higher weights to companies with higher market capitalization. Also the S&P 500 index does not provide any exposure to small-cap companies, which historically produced higher returns.

Index funds

Speaking of investment options, an investor may consider an index fund, which can provide the benefits of broad market exposure, low operating expenses, and low portfolio turnover.  An index fund consists of a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index. The risk of underperformance in index funds is low because they contain stocks from several sectors and industries, thereby, essentially diversifying your investment portfolio. Investing in specific stocks can erode your capital if the stocks underperform while investing in an index fund an reduce your risk exposure. For passive investors who don’t do research, and monitor the performance of their investments actively, these funds provide an avenue to invest over the long term while minimizing the risks.

Mutual funds or Exchange Traded Funds (ETFs) are examples of index funds. Instead of a portfolio fund manager actively picking stocks and market timing – that is, choosing securities to invest in and strategizing when to buy and sell them – the fund manager builds a portfolio whose holdings mirror the securities of a particular index. The theory is that by mimicking the profile of an index – the stock market as a whole or a broad segment of it – the fund will match its performance as well. Legendary investor Warren Buffett has recommended index funds as a haven for savings for the later years of life. Rather than picking out individual stocks for investment, he has said, it makes more sense for the average investor to buy all of the S&P 500 companies at the low cost that an index fund offers.

However, there are also disadvantages to investments in index funds. The lack of flexibility limits index funds to well-established investment styles and sectors. The index funds can merely follow the downward trend of the “surrogate” stock index or the index fund might not track the underlying index or sector exactly causing tracking errors or variances between the fund and the index. Some index funds might only hold a few components and the lack of diversification can expose investors to the risk of losses. It is important that the fund manager is actively and closely managing the fund, though not all their investment strategies may be successful.

Back to basics

While many new and innovative investment options have come out in the local and global capital markets, the basic principles of investing remain. If I may mention a few:

• Set realistic investment goals

• Develop a financial game plan as investment types perform differently

• Know your financial limitations and invest with a margin of safety

• Diversify and rebalance your portfolio regularly

• Be aware of the risks and protect against losses

• Think long-term

The author, Ma . Aurora “Boots” D. Geotina-Garcia, is chairperson of SharePHIL. She is also President of Mageo Consulting, a company that provides corporate finance advisory services.

To learn more about SharePHIL, visit https://bit.ly/m/sharephil