| FREQUENTLY ASKED QUESTIONS |
5. How is a benchmark used for tracking ?
What is a tracker ?
A "tracker" is the general term used by
analysts to describe a system or method used to follow or "track" a particular
market. If a certain market possesses the characteristic of being able
to achieve a certain annual return percentage consistently, the ability
to track that particular market becomes important.
Close tracking exposes an investor to the
risk and return percentages approximating those of a market.
A tracker involves the use of a method
or system and required information to enable an investor to closely monitor
the price movements of a selected market with the objective of matching
or doing better than its performance.
In order to track a market, it is important
that indicators of market movements are available. All markets provide
movement indicators through "indices". Indices are usually constructed
using the weighted averaging method.
For example, if an index is made up of
50 stocks, the market value of all the 50 stocks at close of market are
added up and divided by the number of shares outstanding. The resulting
index number is expressed in points. The component stocks of indices are
usually published.
Knowing what a particular index stands
for is important. Indices are built to reflect different aspects of a market.
For example, the performance of the best companies in a market is reflected
in its blue-chip index. Another popular index these days is one reflecting
the performance of its high technology segment (a hi-tech index).
A benchmark can, therefore, be used as
a marker to compare the performance of an investment or a portfolio. To
do this, an investor will have to invest in a "basket" or portfolio of
stocks and select a benchmark or index to compare the movement of the portfolio
against that of the selected index.
Remember that an index is an average number.
To invest in one stock hoping to match the performance of an index can
be statistically difficult unless that particular stock represents a very
big percentage of the index.
Investing in a number of companies that
are components of an index that constitute a big percentage of the index
will give you a better statistical chance at being able to match the market
performance (both upside and downside).
The key to tracking an index is the composition
of your basket of stocks. Your portfolio need not include all the component
stocks of an index in order to track the index. All you need is to ensure
that a percentage of your portfolio are invested in the index component
stocks.
Hence if 30 per cent of your portfolio
is invested in index component stocks, then you can expect that when the
index moves, only 30 per cent of your portfolio is sensitised to the index
movement.
Tracking a benchmark is useful because
it shows you the potential market returns and risks of investing when using
a certain index. Many market players are unaware of the major differences
between speculating and investing.
When speculating, the risks and returns
are not known. It is always the gut feel. You can achieve astounding gains
or lose more than your capital if you are speculating using margin. Speculation
is almost always associated with instant wealth fables or stories of misery.
When investing, you measure probable returns
and risks. In benchmark investing, your returns can only be as good or
a little better than the index which you use. Your risks of losing are
only as much or a little worse than the index. Benchmark investing is a
simple way of knowing from historical averages what are your market risks
and returns on an investment.
How is a benchmark used for tracking ?
In October 1988 after the infamous
October 17 Crash of the Dow, the KLCI-80 Index (it comprised 80 stocks
then) registered a low of 222 points. The KLCI-100 Index (the index was
adjusted to comprise 100 stocks in 1990) rose to a high of 1333 on January
4, 1994.
The Asian Financial Crisis collapsed the
market to a low of 262 points in September 1998. It has since recovered
to around 950 points in April, 2000.
From these numbers, it can be seen that
from the October 1987 low to the high of January 1994, the KLCI recorded
an absolute return of 600 per cent over the period of 6 years and 3 months.
This translates into an annual compounded return of 33.0 per cent.
In the same way, the compounded annual
return from September 1999 to March 2000 (a 17 month period) when the market
rose from 262 points to 950 points, it increased by an absolute 362 per
cent over the period or at an astounding compound rate of 115 per cent.
In terms of risk, if you had invested in
January 1994 when the index was around 1300 points and kept your investments
till September 1998 when the index fell to approximately 260 points, you
would have had paper losses of around 80 per cent.
A benchmark is therefore a very useful
marker for tracking investment returns and risks. Hence, knowing how the
index reacts to changes in its component stocks is critical to the success
of benchmark investing.
To learn more on index or benchmark investing,
please click under the Investment Strategies Section
(Example using the
Kuala Lumpur Composite Index - KLCI is used)