What Is Indexing And How Does It Help You Understand If You Are Getting A Good Return?

What Is Indexing And How Does It Help You Understand If You Are Getting A Good Return?

Posted by Clay Schmidt on Dec 24, 2020


If you own an investment that returns 8%, is that good? How do you know? If you’re satisfied with 8%, what are you basing that satisfaction on? Indexing a way to help answer these questions.

Indexing measures the comparative performance of two or more investments. It works by benchmarking an investment to a similar well-known, broadly used investment vehicle. For example, a S&P 500 ETF would be benchmarked to the S&P 500 index. In other words, it tracks the S&P 500 index and is expected to perform similarly to the S&P 500.

A benchmark isn’t always an index. It might be another fund, the inflation rate, or whatever the manager of the investment chooses. In searching for an adequate/proper benchmark, the manager is looking for a yardstick to compare against. This will help to answer the question for investors — is this a good investment?

Indexing Performance

To see how indexing works, let’s look at some examples. Investment A is benchmarked to index B. A returns 5% while B returns 8%. In this case, A didn’t match its benchmark or even beat it. Let’s say that in the following year, A returns -2% while B returns -5%. Even though they both had negative returns, A did better than its benchmark.

Looking specifically at real estate investments, if we consider that Delaware Statutory Trusts (DSTs) return on average 6-7% (after-tax return of 4-6%) and the 10-year average return (ending in 2018) of the S&P 500, including dividends, is ~13.6% before taxes, the stock market has better returns. For additional comparison, from 2010 to 2019, the NCREIF Property Index returned 2.5%.

Is it wrong to compare DSTs (or even real estate in general) to the stock market? Investors can choose any benchmark that they like, but it doesn’t always mean it's a good comparison. Let’s take the DST to stock market comparison. To pursue the 6%+ of additional returns, an investor would have had to hold through a lot of volatility. DSTs are typically not as volatile as the stock market. This is due to the lack of real-time price discovery (i.e., illiquidity) in real estate.

Managing volatility may mean better preservation of capital. During the above mentioned 10-year average return for the stock market, the swings were from -4.4% up to 32.4%. Whether an investor could sit through such volatility without selling some of their assets is another topic of discussion but certainly an important one to consider.

We also did not factor in after-tax considerations. Stock gains are only offset by other investment losses. However, real estate has a number of ways to offset gains, including pass-through expenses and depreciation.

When considering investments, we can’t just look at benchmarks. It’s important to take a more comprehensive picture of the investor’s profile. While DSTs are not for everyone, it’s always important to fit suitable investment to the investor, which is what we’ll look at next.

Life Stage Considerations

Someone in their 20’s is more suited to allocating more of their portfolio to the stock market than someone in their 60’s. The closer an investor gets to retirement, the more concerned they are about capital preservation. This often comes with the understanding that most of their gains have already been made and that any portfolio income will likely be lower than when they were younger.

Given the lower volatility of real estate, it can help better stabilize a portfolio while potentially generating some income. That’s just another way of saying that real estate can help diversify a portfolio. People who are at a later stage in their life prefer to avoid stock market volatility. But instead of going straight to cash, they’d like their investments to perform (i.e., generate income and appreciation). Real estate can help to fill that need.

As investors move through life, working with a financial advisor who can allocate a portfolio to an investor’s life situation will help in meeting financial goals. That’s why it's always important to have good financial and tax advisors on your side.

The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock's weight in the index proportionate to its market value. You cannot invest directly into an index. 

Past performance is not a guarantee of future results. All investing involves risk, including the loss of principal.

There is no guarantee that the investment objectives of any particular program will be achieved. The actual amount and timing of distributions paid by programs is not guaranteed and may vary.

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