The above graph shows the immense growth of the Israeli Stock Market. From the beginning of 2006 until last week, the TA25 made a whopping 33% return. This immense growth is evident by what I call the “hedge fund commercials” indicator. Business is good for hedge funds in Israel and these days you simply can’t escape all the commercials trying to convince you to put money in their funds. For those who want to know how to chose the right fund, you can check out the post I made about comparing returns of funds.
The index as a reference tool?
It has occurred to me that most of the general public does not know how to decipher returns of funds. The biggest obstacle for the general public is probably when it is faced with numbers that make no sense. There could be a fund making 26% this year. There could be another with 17%. The public can’t judge how good are these returns if it has no perspective. What is a good return? Would your opinion change if a fund made 25% in Israel but the index itself 33%?
Knowing how much the index has returned can give us a little perspective on what are good returns. We could argue that we would have been better of just buying an index fund that would have given us the 33% and let that be our gauge. The problem is that it doesn’t tell us the full story of the risk involved. Some funds take more risks. Other take less risks. Here is an example: Let’s assume that fund A had returns of 40% this year. They beat the index who only made 33% this past year alright. But what if they had taken more risks in the form of leverage? Let’s assume for simplicity they had taken on average 50% of leverage. Could we still compare it to the index which made only 33%? We certainly can’t. They assumed more risk.
Risky business
Consider again the example above. What would have happened if we would have taken the same 50% risk? If we invested $100 for instance, we’d take a loan for $50. At the end of the year we’d have 33% on $150 which amounts to $49.5. From that we’d have to pay back the $50 plus interest (assume 5%) of $2.5. We’d be left with $147. This amounts to 47% returns. This means that given the same risk we undertook as the hedge fund did, we achieved higher returns.
This small example above shows you that even comparing just the index with other fund returns isn’t enough. You also have to know how much risks the fund takes. Do they use leverage? do they invest all their money in stocks or diversify in other investments? All of these has to be taken into account. Remember, when there is a bull market like there is now, you can’t allow yourself confuse luck with skills.
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