When considering the expected return of an equity market index, it is important to understand the underlying components, or sectors, from which the relevant index is derived.

While global factors such as bond yields, commodity prices, and currencies will impact all equities to some degree, the composition of the index will also have a significant impact on investment returns.  Understanding the sector weightings of each index, and the investment fundamentals driving each sector, can provide opportunities for diversification to enhance risk-adjusted returns.

To illustrate, the Australian share market returned 13.2% over the 12 months to September 2016, as measured by the S&P/ASX200 Accumulation index. This is well below the 31.6% returned by New Zealand’s S&P/NZX Gross Index. The superior performance of the New Zealand market can be partly explained by differences in index composition.

The individual sectors of the New Zealand and Australian indices are charted below. The key features of the Australian index that differentiate it from the New Zealand index are (i) the large size of the Australian Financials sector (primarily the big four banks) ; and (2) the Metals and Mining sector. Similarly, the New Zealand market has a much larger weighting in Utilities, Industrials (Infrastructure) and Healthcare – sectors that have been extremely  well supported over the past year as interest rates and global growth have remained low, increasing the demand for higher yield and higher growth equity investments.

Source: IRESS

The market capitalisation-weighted method of calculating the Index level means that performance will be heavily influenced by the largest sectors.

Over the year to September 30 the Australian banking sector was flat in absolute terms, resulting in 7% underperformance relative to the broader market. The main drivers of this relatively poor performance have been (1) increased mortgage competition resulting in lower net interest margins; (2) regulatory changes requiring additional capital to be held by banks, and (3) concerns that the bad debt charges may once again become a headwind for earnings.

Excluding the bank sector, the Australian market returned closer to a healthier 16% over the year.

More recently, the Australian banks have been performing well, having priced in the risks from these negative headwinds. Resource companies have also been well supported on the back of stronger commodity prices.  This has driven strong performance of the Australian share market relative to the New Zealand index.

Wayne Gentle

Head of Australian Investments

Disclaimer: This is intended to provide general information only. It does not take into account your investment needs or personal circumstances and so is not intended to be viewed as investment or financial advice. Should you require financial advice you should always speak to an Authorised Financial Adviser.