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When it comes to the investment performance of your super account, funds love to talk about how much they have outperformed the index or benchmark.
But what does that really mean? And what the heck is an investment index anyhow?
To help you cut through the jargon, here’s an uncomplicated explanation of investment indexes and why they can be useful tools for learning a little more about the performance of your super account.
A simple guide to investment indexes
For investors, an investment index is like a ruler or a tape measure. It’s a simple tool for measuring the performance – or price movements – of investment securities like shares and bonds.
Indexes are created to make it easier to monitor the performance of a particular investment market. They also represent the universe of assets in a particular market from which an investor can choose.
Investment indexes are the foundation for investments vehicles like exchange-traded funds (ETFs), which allow you to buy a single investment that tracks the performance of an entire market.
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What investment indexes are available?
There are thousands of different indexes, each representing all or part of a particular investment market.
Each index groups together similar assets. It can cover the industry companies belong to, different sized companies, or the region in which a company is based.
A simple example is a share market index like the S&P/ASX 300 Index, which measures the performance of a basket of securities consisting of 300 companies listed on the Australian Securities Exchange (ASX).
Investment indexes also track the performance of specific market sectors (such as financial, resources and technology companies) and asset classes (such as bonds, commodities, cash or fixed interest).
How indexes work
Investment indexes are generally created by huge investment firms like Bloomberg and Standard & Poor’s, which calculate and monitor the price of the selected group of investment securities.
The changing price of the assets in the index determines its value. As the prices of the assets go up and down, the value of the index follows.
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5 reasons indexes matter for your super
Investment indexes can provide valuable information to super fund members:
1. Monitoring investment options
Indexes make it easier to monitor the performance of your chosen investment option. Every investment option has a particular benchmark against which the fund trustee measures the performance of the investment manager.
The index will vary depending on the investment option. For Australian shares the benchmark could be the S&P/ASX 300 Accumulation Index, while for International shares it is often the MSCI All Country World Index. Cash investment options are often measured against the Bloomberg AusBond Bank Bill Index.
Investment indexes help you compare ‘apples with apples’. Unless you know the investment index your super fund is aiming to match or beat, you cannot accurately compare its investment performance with another super fund.
2. Insights into investor sentiment
Indexes provide information about changes in investors’ feelings towards a particular market. When investors are feeling positive about individual market sectors or countries, demand for securities in that market go up and prices rise, so the index also goes up.
For super funds, these insights help fund trustees decide if they need to shift their current allocation of investment assets between different asset classes in the hope of delivering higher investment returns to fund members.
3. Passive investment
Investment managers who use a passive or index style, use indexes as a tool to diversify their portfolio and to deliver the performance of a selected market. They do this by investing in all or a representative sample of the securities in the relevant index.
Super funds often use passive investing as a cost-effective way to buy an entire market or a representative sample of it. This means fund members receive a similar investment return to the relevant market – at a lower cost.
4. Sorting assets
Most investment markets consist of thousands of individual securities from which your super fund’s investment managers can choose. Indexes can be a useful tool to help sort between all these different assets.
When it is being constructed, an index classifies shares (and other types of assets) based on characteristics like the size, sector or industry in which the company operates. Super funds use this information to help with the selection of their investment assets.
5. Representing the market
An investment index is considered to be a broad representation or proxy for the entire investment market (or market segment) they are constructed to track. For example, the Dow Jones Index in the US tracks just 30 large industrial companies, but is viewed as a representation of how the US share market as a whole is performing. Similarly, the US Aggregate Bond Market Index serves as a popular proxy for the enormous US bond market.
By aiming to match or beat the performance of an index, super funds can ensure they are delivering the same performance as the underlying investment market to members.
Indexes: what they tell you about super fund performance
Sometimes it can be hard to know how well your investments or super fund are performing. That’s where an investment index can come in handy.
If your investment option delivered a similar performance to its investment benchmark, your super fund – and its investment managers – have done their job. If it has outperformed the index it’s a great result and you should be very pleased.
But if your investment option underperforms the relevant index by a large margin for several years, it might be time to ask some questions or consider switching investment option. Every portfolio will have years where it underperforms, but if it lags its benchmark for multiple years, there may be problems.