Security Market Indices

Market indices have several primary purposes:

• They help us gauge market sentiments.
• They act as proxies for measuring returns and risk.
• They serve as proxies for asset classes.
• They benchmark active managers.
• They model portfolios for index funds and exchange-traded funds (ETFs).

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.

Since the S&P 500 is based on the largest 500 liquid and publicly-listed stocks in the United States, it would not serve as an appropriate benchmark for a US small-cap equity fund or a global large-cap fund.