CONTENTS

1. What is a tracker ?

2. What is a benchmark ?

3. Why a basket of stocks ?

4. Why use tracking ?

5. How is a benchmark used for tracking ?

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.

What is a benchmark ?

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.

Why a basket of stocks ?

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.

Why use tracking ?

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 ?
(Example using the Kuala Lumpur Composite Index - KLCI is used)

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 (Benchmark Basics).