Utilising stock indices 2 comments

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I have just come up with an Energy Sector Index on top of my earlier China Stock Index, given that there are no comparable indices for these sectors/themes on the SGX. Somebody asked me what was the best way to use these indices and I thought I'd write about some suggestions here.

Firstly, market indices or sector indices can be used to track the fortunes of the general market or sector respectively, and compare(or contrast) the performance of one's portfolio picks against the index, which indicates the average performance. That should be pretty obvious to all market players. I have mentioned in an earlier article about benchmarking portfolio performance: on the first level of benchmarking you benchmark against the broad market performance; however on the second level it makes sense to benchmark your individual sector performance (assuming you perform sector allocation in your portfolio) against the relevant sector indices. Otherwise you might possibly be outperforming the market but underperforming your individual sector; not good to find out but good for self-evaluation.

Secondly, these indices provide a good basis for development of an index portfolio if one is really keen on the sector. Ok, maybe not, more like some specific stock picks since we're not managing big funds here. Index stocks represent the largest market-cap stocks in the particular sector, which are more likely to be in the radar screens of fund managers. Ultimately we're trying to find stocks that the fund managers would buy, because that's where the big money's coming from. But don't take the index component stocks as the best; maybe you should check out my HotStocksNot blog for any views on that particular stock (note that there're a few index stocks I've previously recommended against buying for both my Energy and China theme indices) ;-)

Thirdly, a view of the long-term performance of a particular sector index against the general market index provides an idea of the correlation between the two. By correlation I mean the sector's response toward a directional move by the general market. Some sectors, like banks, enjoy strong correlation with the general market (partly also because they are major components of the market index); some sectors/themes only exhibit patchy correlation (eg. SESDAQ small-caps vs STI sometimes); some themes might even have negative correlation (eg. healthcare might rise when STI falls because of their defensive characteristics). It might be useful to note, for example, if a sector is underperforming the STI although historically it has had a high direct correlation to the latter; it might suggest an investment opportunity.

That is the purpose of market and sector indices, and I hope my two new indices will be useful for readers who are optimistic about the Singapore market.