Nightly news bulletins keep us informed about the performance of markets by showing changes in indices such as the ASX 200. This raises 2 questions. What is an index and why should we care if it moves up or down?
An index is essentially a calculation measuring the value and related movement of a section of the market. Indices are made up of stocks that meet a certain criteria. In the case of the ASX 200, the criteria used is market capitalisation or “market cap”.
Market cap is the share price of a company multiplied by the number of shares they have on issue. Therefore, the ASX 200 index represents the 200 largest companies on the Australian stock market, and measuring their performance provides a snapshot of how the general market is behaving.
Movements in indices also allow us to compare the performance of a managed fund or an individual stock against the general movements of a certain sector or the market as a whole.
The ASX 200 is one of the most prominent indices in Australia and has recently hit 5983, which is the highest it has been in 7 years. Each company influences the ASX 200 relative to the size of its market capitalisation, and a company’s influence on the index will change over time. A good example is when we compare Commonwealth Bank (CBA) and BHP Billiton (BHP), both now and at the height of the resource boom in 2011.
CBA’s market cap is around $150 billion at the moment, making it the number 1 stock in the ASX 200 index. BHP on the other hand is $100b, putting it in 3rd place. However, back in 2011, BHP’s market cap was $180 billion, well above CBA at $90b. There are many factors that can influence the value of a company over time, and that is why indices are ‘rebalanced’ every few months to reflect these changes.
What’s fueling recent gains in the ASX 200?
There are a range of factors. Firstly, the ASX 200 has been influenced by low domestic interest rates, and an international inflow of funds. International investors are interested in Australian stocks for a variety of reasons. They are attracted to our relatively high dividend yields – compare our 5% dividend yields to the zero interest rate policies or money printing by some international central banks.
Secondly, when investing, international funds prefer ‘deep’ stocks – which refers to the large market cap companies, as they are easier to buy and sell.
The recent depreciation of the exchange rate has also encouraged international investors, as it has reduced the cost of investing. The depreciation of our currency rate has been orderly (unlike the recent depreciation of the Russian Ruble) and appears to be finding a steady level. All of these factors, together, help make Australian stocks an attractive option.
However international investors are not only interested in our stock market, they are also making the most of the our comparatively higher interest rates. Our ten year rate is at around 2.4% which looks attractive against the German rate of around 0.3% for instance.
Funds that replicate an index are known as exchange traded funds (ETFs). ETFs are considered attractive because of their diversification (they provide investors exposure to a number of stocks) and most carry low fees.
ETFs can be used in a “passive” investment strategy, as you are not “actively” trying to beat an index; rather just replicate it. Some academic research has shown indices can outperform actively managed funds after fees. For example, an S&P Dow Jones study in 2014 suggested nearly three-quarters of all actively managed funds focusing on the top 200 stocks underperformed the comparative index funds over the past 5 years. We won’t go into the detail here, as “active vs passive” investment is a whole other debate which we’ll save for another feature article.
