A Way to Measure Performance…Or Can We Use It to Make Money?

Whether we like it or not, someone is always watching our performance. If you work in sales, for example, you’ll have monthly targets to hit. Miss them too many times, and you could find yourself in the corner office, having a ‘bit of a chat’ with your boss.

And if you work in manufacturing, there are strict tolerances to meet. Sure, everybody wants their products made from the best available materials. But irrespective of how strong they are, nobody wants a box of bolts that are all slightly different.

Whether it’s a profit target for an executive, or a timed run for a football player, there are benchmarks that help us gauge how we’re performing.

In the stock market, the most common benchmark is the index. Of course, there are multiple indexes that investors use. But the most common index is the S&P/ASX 200, which gauges the performance of the 200 largest stocks on the ASX.

The whole point of introducing the index was that fund managers could gauge how they were performing. Or more to the point, investors could see if their fund manager was any good.

If a fund manager can regularly beat the index — something extremely difficult to do — they can expect investors to beat a path to their door.

Is this its real purpose?

While indexes are a way to gauge investment performance, they have also become a product to trade. Historically, it’s been the futures exchanges that offered index products.

In Australia, the ASX offers the SPI (share price index) 200, which, as the name implies, is based on the ASX 200 index. It’s among the ASX’s most popular contracts. The SPI 200 futures contract enables you to trade both directions of the market.

Investors are often more familiar with the long side. That is, buying when they think the index is on the way up. However, a futures contract allows them to short the market as well. That is, traders can sell the index if they think the market is heading for a fall.

When you short sell shares, you first need to borrow them. That’s because at settlement you have to hand the shares over to the buyer.

However, it’s different when you sell a SPI 200 contract. Settlement doesn’t actually take place until the futures contract expires — which might be several months away.

In the meantime, though, your position is ‘marked-to-market’ each day. Meaning that if your trade goes your way, money goes into your account at the end of the day. And if against you, comes out at the end of the trading day.

Of course, not everybody who trades futures is speculating on future price moves. A fund manager might sell SPI 200 futures contracts to hedge their existing shares. If the index falls, the value of their short futures position will increase, helping offset a fall in their shares.

Not just for the big hitters

For many investors, however, the world of futures might not appeal. At $25 per one-point move in the SPI 200, a 100-point fall represents a $2,500 hit to their account (if they’re long). Plus, setting up a futures account can sometimes involve high minimum account sizes, and plenty of paperwork.

To cater for those who don’t want to take these kinds of swings, CFD (contracts-for-difference) providers also have index-based products. However, with CFDs, you have more flexibility in the size of the position you take on.

You can trade an index CFD that is only $1 per one-point move. So if the market drops 100 points, you’re not going to suffer the same losses as you might with a futures contract. Once you’re more comfortable with CFD products, you can always ramp up the number of contracts you trade.

But if CFDs don’t appeal either, there are other ASX listed products you can trade as well. For example, both the SPDR S&P/ASX 200 [ASX:STW] and iShares S&P/ASX 200 [ASX:IOZ] enable investors to buy the index through the one holding.

Typically, though, investors don’t trade in and out of these types of ETFs. They use them as a way to generate market returns, not to speculate for quick-fire gains. Because of that, investors might hold these types of ETFs for the long term.

However, there are also ETFs that allow you to trade the short side. These ETFs short the index by selling futures contracts on the ASX SPI 200. Because these short ETFs work inversely to the direction of the market, you profit when the market takes a fall.

One short ETF is the BetaShares Australian Equities Bear Fund [ASX:BEAR], which roughly gains 1% for every 1% fall in the index. And there’s also a leveraged version — the BetaShares Australian Equities Strong Bear Fund [ASX:BBOZ].

With BBOZ, a 1% fall in the index will produce an increase in the fund’s value of between 2–2.75%. Though it works both ways. If you get it wrong, the leverage will also accelerate your losses.

If you don’t think derivatives are for you, then these ETFs can help you trade both directions of the market. You can buy into the ‘long’ ETF when you think the market is going to rally. And if you think the market is going to reverse, you can close it out and buy a ‘short’ ETF.

Matt Hibbard,
Editor, Total Income

Editor’s note: The above article was originally published in Markets & Money.

Money Morning Australia