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.
- Gauges of Market Sentiment: the original purpose of indices was to get a sense of investor confidence and market sentiment.
- 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.
- 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.
- 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.
- 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.
What type of actively-managed fund might use the S&P 500 as a performance benchmark?
A. US small-cap equity fund
B. US large-cap equity fund
C. Global large-cap equity fund
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 for a global large cap fund.
Reading 45 LOS 45g:
Describe uses of security market indices