Security Market Indices

The primary uses of market indices are to (1) gauge market sentiments, (2) serve as proxies for measuring returns and risk, (3) serve as proxies for asset classes, (4) benchmark active managers, and (5) model portfolios for index funds and exchange-traded funds.

1. Gauges of Market Sentiment: the original purpose of indices was to get a sense of investor confidence and market sentiment.
2. Return/Risk Proxies: indices play a useful role in the capital asset pricing model as a certain index (like the S&P 500) sets the expected return and risk for the overall market. Beta (systematic risk) can then be calculated for individual securities based on their covariance with the index, and alpha (risk-adjusted excess returns) can be calculated for active managers.
3. Asset Class Proxies: Future assumptions regarding the return and risk profiles of certain asset classes are largely centered on how various broad indices have performed in the past.
4. Active Management Benchmarks: indices can also be useful in judging the relative performance of active managers as long as the selected benchmark targets the same markets as the active manager.
5. Model Portfolios: indices dictate the investments and weightings of index funds and exchange-traded funds, which help investors gain passive broad exposure to certain markets – usually at a lower cost than active management.

Question

What type of actively-managed fund might use the S&P 500 as a performance benchmark?

1. US small-cap equity fund.
2. US large-cap equity fund.
3. Global large-cap equity fund.

Solution

The correct answer is B.

• S&P 500 Index: The S&P 500 is a benchmark index that represents the performance of 500 of the largest publicly traded companies in the U.S. It is designed to reflect the performance of large-cap U.S. stocks.
• US Small-Cap Equity Fund: This type of fund focuses on small-cap stocks, which are typically companies with smaller market capitalizations than those included in the S&P 500. Using the S&P 500 as a benchmark wouldn’t be as relevant for a small-cap fund, which would more likely use a small-cap index like the Russell 2000.
• US Large-Cap Equity Fund: This fund focuses on large-cap stocks, which are the types of companies included in the S&P 500. Using the S&P 500 as a benchmark makes sense here, as it represents a broad cross-section of large-cap U.S. equities.
• Global Large-Cap Equity Fund: This fund invests in large-cap stocks from around the world, not just the U.S. While it might use multiple benchmarks to reflect its global exposure, the S&P 500 would be just one component of its performance comparison, and it would not be the sole benchmark.

Thus, the most appropriate benchmark for a US large-cap equity fund is the S&P 500.