Tuesday, July 13, 2010

Understanding Index Investing

INDEX investing may sound like Greek to some although it is already a growing trend in Hong Kong and Singapore over the past five years. The other Southeast Asian countries are playing catch-up with index investing as more investors are aware of this opportunity for them to gain potential higher returns.

However, before we go into index investing, let us understand what an index is in the first place.

When we read the market commentary in the daily newspapers or listen to market up dates on television, we almost always come across statements such as "the market performed well today" or "there was a bull run on the market today". The word "market" is used liberally but what does it actually refer to?

When people talk about the "market" in relation to the stock market, they are actually referring to an index. For Malaysia, an example of an index is the FTSE Bursa Malaysia Kuala Lumpur Composite Index, better known as the FBM KLCI. Therefore, if you hear: "the market is up," this means the FBM KLCI is higher compared to the previous day.

So, is an index important? And if yes, why so? An index is important because of what it represents. The beauty of an index is that it is extremely easy to understand and investors know exactly what they are acquiring by putting money in an index.

It is too demanding to track every single share trading on the stock exchange, hence, an index that tracks the more "relevant" shares are created. These shares are usually the heavyweight stocks with more market capitalisations.

When these heavyweight stocks appreciate, the entire bourse goes up and when they lose value, the entire stock market trends down. In coming out with an index, the index provider must first define exactly what criteria is used to select shares for a given index.

Creating an Index

An index is made up of a basket of stocks. Therefore one must understand that it can be created to represent any segment of the stock market. One of the more widely known indexes in the world is the S&P 500 Index created by Standard and Poor's Index Services. The S&P 500 represents 500 of the most widely held firms in the US such as Exxon Mobil, Apple, and Microsoft, and the stocks within this index trade on major US bourses such as the New York Stock Exchange and Nasdaq.

Regarded as one of the best barometers of the American equity markets, the job of many American fund managers is to produce returns that outperform this index. Another well-known index, is the FTSE 100 Index that holds the top 100 largest firms listed on the London Stock Exchange. This index is seen as an indicator of the British economy and is the leading share index in Europe.

An interesting thing about indices is that almost anyone can create an index. During the dot-com bull run, almost all the publications in the US created an index to represent different types of new-economy stocks.

However, what sets the big indices apart is the reputation of the company that creates and manages the index. As you go along and get familiar with the various indices, you will start noticing them in every single market and for every sector and industry.

Apart from looking at the index provider, another way to differentiate the indices is to identify the methodology used to measure the importance of each security within its basket. There will always be a stock that is arguably more important than the other. For example, there will always be shares of companies that are more influential to the entire market due to their size or share price.

A common method used by indexes around the world though, is to weigh companies based on their market capitalisation. If company ABC has a market capitalisation of RM1 million and the total value of all the companies within an index is RM100 million, this means that shares of the company would be worth 1 per cent in this index. Such computations are done up-to-the minute with analysis tools, hence making indexes an extremely accurate reflection of its chosen market.

Making money via index investing

It is relatively easy to maintain an index. Except for the occasional fine-tuning, an index only needs to hold on to its basket of stocks from year to year, which means lower costs for an investor. When investing purely in an index, there are no costs involved that goes to fund managers (for their stock picking skills), since there is no active stock picking required. This in return, means more of your money is invested and gets a chance to grow!

With an index, investors get to decide on what and where their money should go. For instance, if you believe that China's economy will continue to grow with each passing year, you could jump on the Chinese bandwagon by investing in an index that tracks the country's main stock market. One of the most popular ways to invest in an unknown market is to do so via index investing because it (the index) is already diversified. This is a quality much desired by investors to smoothen out instability (the losses and gains in the value of your investments).

In most cases, index investing would likely mean investing in the larger leading companies in a stock market with strong brands and significant market share. Though it is possible for the value of an index investment to decline like any other investment, the odds of all leading companies in the index going bust at the same time are low.

In any case, chances are that actively managed unit trust funds with a similar investment universe would also be suffering a similar decline. As such, investors need to consider all the risks involved before making any investment, even with index investing.

Investing in an Index

Making money with an index takes the same amount of time required for an economy to grow - it is a long-term process. There are two ways to invest in an index: via an index unit trust fund or with an exchange traded fund (ETF). For the first option, investors must be aware that not all index funds are the same. A fund company can create and sell index funds but may charge a substantial sales commission and a higher management fee which may compromise the main advantage of index investing, that is its low cost.

The second option to index investing is via ETFs. The main difference between ETFs and standard unit trust funds is that it (ETF) is listed on the stock exchange and trades like a normal share throughout the trading day. In the more matured financial markets, ETFs are growing increasingly popular with investors.

In the next article, we will feature the many advantages of ETFs. The more you understand about the universe of investing and the various instruments available in the market, the better chance of you finding the right investment at the cost and risk level which you are most comfortable with, for your portfolio.

2 comments:

jane said...

Greatly written indeed I really enjoyed your article and found it to be very informative, keep up the good work, Ill be coming back to read any of your future articles..

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Caroline said...

i have read lost of blog similar to this, all has the same content. Thanks for the update.

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