Suppose you have invested in an equity fund whose value has increased by 5% over the period of one year. How can you know whether this increase in value (the “performance”) is good or bad, whether you can be satisfied with your fund or not?
You will firstly compare this 5% with the interest you would have earned if you had kept your money in a savings account at your bank. Given the paltry interest rates that are currently paid on bank deposits, the yield of 5% achieved by your investment fund is certainly higher. However, comparing a risk-free investment in a savings account with a definitively riskier investment in an equity fund is like comparing apples and oranges.
Of course, you can also compare the 5% performance of your fund with another fund that invests in a similar portfolio of equities. But this will not get you very far either: You’ll know if the performance of your fund is higher or lower than that of the other fund, but you still do not know whether the performance of this other fund was good or bad.
Indices are available for nearly all kinds of investments
There are a wide variety of market indices. The most popular by far is the Dow Jones Industrial Average Index (DJII) – or simply Dow Jones – which reflects the performance of the 30 most important stocks that are traded on the American stock exchanges and has been calculated by the news agency Dow Jones since the year 1895.
The Financial Times Stock Exchange 100 Index, better known under the name FTSE 100 or even “Footsie”, reflects the performance of the 100 most important stocks listed on the London Stock Exchange, the CAC 40 is the index for the Paris stock market.
In addition to these “local” indices there is a whole series of indices that track the market performance of larger regions, such as the Stoxx 50, for example, that contains the 50 largest companies of Europe, or the Euro Stoxx 50 with the same number of companies from the euro zone.
Still other indices target specific economic sectors such as consumer goods, real estate, finance, health or telecommunications. Others measure the evolution of prices for various types of goods, such as raw materials, agricultural products or precious metals. Still others focus on the size of the targeted companies: “large-cap” companies or small and medium sized enterprises.
In principle, indices can be established for all kinds of goods traded on an organized market. While statistical methods may differ, the goal is always the same: to document the general evolution of a specific market in an objective and representative manner.
A benchmark helps to evaluate the success of your investment
So you need a reference value – a benchmark – that allows you to evaluate the success of your investment. For investment fund managers – and their customers – this is a (stock market) index which reflects the universe of stocks in which the fund invests.
For a fund investing in German stocks, for example, this will be the DAX index calculated continuously by the Frankfurt Stock Exchange. “The DAX” is calculated based on the share prices of the 30 largest and most actively traded German companies. If stock prices rise, the index goes up, and vice versa. The DAX is considered an indicator for the overall development of the German stock market.
But beware: If the DAX rises by 1%, this does not mean that the share prices of all 30 companies it contains also rise by 1%, far from it. Some stock prices increase more than others, others increase less, still others even fall.
What does this mean for our investment fund which invests in German equities?
Well, if the DAX has risen by 10% during a given period, while the value of our investment fund increased by only 4% during the same period, this means that the fund manager did not benefit from the generally good performance of the German stock market and that he did not make a good choice when selecting the stocks in which he invested the money the investors entrusted to the fund.
However, if the value of our fund increased by 13% over the same period for example, this shows that the fund manager had a fine flair to identify those securities that have increased more than the average.