When you own hundreds of individual common stocks through an index fund or ETF, some stocks will do better than the index while others will do worse than the index.
In the end, the index mutual fund and ETF should closely match the index performance
But what determines the performance of the index?
There are four primary drivers of stock market index returns. When these four drivers are added together, they closely approximate the performance of the index.
Each of these performance drivers corresponds to a column in Asset Camp’s historical stock market return table.
The four drivers are:
1. Dividend Yield: A dividend is the portion of corporate profits paid to common stock shareholders as dividends. In our historical return model, cash flow is expressed as the average dividend yield for the past ten years. A stock’s dividend yield is its annual dividend divided by the stock’s ending price.
2. Earnings Growth: A stock’s cash dividend can grow if the company’s earnings or profits grow. In our model, we show the index’s annualized growth in earnings over the past decade.
3. Valuation adjustment: The stock price is the consensus of what investors are willing to purchase or sell a stock. That consensus price can vary over time. One measure of what investors are willing to pay for common stocks is the price-to-earnings ratio or P/E ratio.
The trailing P/E ratio of a stock is its current price divided by its earnings per share over the past year. The P/E ratio measures what investors are willing to pay for one dollar of earnings.
For example, a P/E ratio of 20 means the investor consensus is to pay $20 for one dollar of earnings.
When investors pay a higher P/E today versus ten years ago, it leads to higher historical returns for stocks and stock indexes.
When investors pay a lower P/E today versus ten years ago, it leads to lower historical returns for stocks and stock indexes.
In our model, we show the annualized performance impact of changing valuations as reflected in the increase or decrease in the price-to-earnings ratio.
4. Currency impact: All returns shown in the historical returns table are denominated in U.S. dollars. The dollar’s value relative to other currencies varies over time. Currency fluctuations can impact index returns when the home currency of the stocks that comprise the index differs from the currency used to show returns.
In our model, the currency impact reflects whether the dollar strengthened or weakened relative to other currencies.
When the dollar strengthens, the currency impact is negative as returns expressed in local currency are higher than U.S. dollar returns.
When the dollar weakens, the currency impact is positive as returns expressed in local currency are lower than U.S. dollar returns.
Users can calculate the local currency return for the specific index by subtracting the currency exchange impact figure from the 10-year annualized nominal return.
For example, suppose the 10-year annualized return is 10% and the currency exchange impact is 2%. In this example, the local currency return is 10% minus 2% = 8%.
If the 10-year annualized return is 10% and the currency exchange impact is -2%, then the local currency return is 10% minus -2% = 12%
Combining the Factors
The sum of the dividend yield, earnings growth, valuation adjustment, and currency impact is compared to the 10-year nominal return for each index. Any difference, positive or negative, is captured in the unexplained variable.
This unexplained variable represents the residual amount that wasn’t captured by the other variables, such as dividend yield, earnings growth, etc.
All statistical models including Asset Camp’s historical stock market return model are simplifications used to explain a particular outcome. No model is a perfect fit for describing an outcome so there will usually be a slight error term or residual.
In most cases, the unexplained variable will be less than 1% as the vast majority of an index’s return can be explained by the dividend yield, earnings growth, valuation change, and the currency impact.
Short Math Note
The historical return attributions are derived from data provided by MSCI. Unfortunately, when the beginning or ending earnings amount is negative, mathematically we can’t calculate the performance attribution. We’d love to, but the math won’t allow it.
In those rare cases, where there are negative earnings (and a negative P/E ratio) for a specific index, we still show the 10-year annualized return, dividend yield, and beginning and ending P/E ratios. We don’t show the other variables and state, “Can’t be calculated due to negative earnings.