A performance-based index is a stock index that adds the amount of all dividend payments, capital gains and other cash disbursements to the net stock price. When measuring the performance over a given time period, the performance-based index will add these transactions to the net share price before calculating the index return.
In contrast, a non-performance index calculates returns on weighted market value without regard for cash disbursements like the S&P 500. Some investors believe a performance-based calculation produces a more accurate measure of performance than the price approach.
Breaking Down Performance-Based Index
A performance-based index differs from a price index in that performance equals the sum of corporate events and price movement. A price index, on the other hand, considers capital gains or losses of a security without regard for cash disbursements like dividend payments. Most US stock indexes are calculated on a price index. However, many large European have adopted a performance-based calculation like the German stock market index DAX. Hence, the DAX, a benchmark of 30 blue-chip companies in Germany, quotes the price with dividends reinvested. This can confuse investors comparing headline prices between different countries.
For instance, the DAX could appear to outperform a non-performance index in a given year, but the truth is price returns of the German index may be aligned with the other markets. This can help explain why the DAX attained record highs in recent years compared to other European markets like the FTSE 100 and CAC 40.
To see a fair one-to-one contrast, it is important to compare portfolio returns with the performance-based version of an index. A total return index will always appear higher than the price return index as it includes additional factors that are incapable of turning negative. It is fine to track the price return index, but it is a good idea to use the total return index when measuring or comparing the returns of a portfolio with an index. This represents the total amount an investor would take home beyond just capital gains.
Benefits of a Performance-Based Index
Since a performance-based index incorporates all capital generating mechanisms, it provides investors with a more accurate depiction of performance. This may not be significant for the casual market observer, but an ardent investor requires a performance-based measure to manage risk and position sizing effectively. Many of the other benefits that come with a performance-based index replicate a total return index, including diversification and lower fees.