Exploring the Uses of Market Indexes | CFA Level I Equity Investments

1. Gauging Investor Confidence and Market Sentiment

Initially, stock market indexes were created to measure investor confidence or market sentiment. For instance, a portfolio manager might want to gauge the US market’s sentiment to decide whether to overweight or underweight US stocks. While the Dow Jones Industrial Average is popular, it might not truly represent the market sentiment since it consists of only 30 stocks. A broader index like the S&P 500 could be more appropriate.

2. Measuring Risk and Return of an Asset Class

Indexes also help determine an asset class’s risk and return. A portfolio manager can study the historical returns of the S&P 500 index to estimate US stocks’ expected return and standard deviation. This is especially helpful when deciding how much to allocate to a specific asset class.

3. Assessing Beta and Risk-Adjusted Return

Indexes can be used to estimate beta and risk-adjusted returns. Let’s remember the capital asset pricing model (CAPM) requires an estimate of beta and the market portfolio’s return to calculate a stock’s expected return. If a manager wants to add a US stock to their portfolio, they can use the S&P 500 portfolio returns as a proxy to estimate the stock’s beta and calculate the market portfolio’s return in the model.

4. Benchmarking Manager Performance

Indexes help assess a manager’s performance against a benchmark. To accurately evaluate a manager’s skill, the chosen benchmark index should align with their investment approach, style, and market. For instance, if the manager operates a fund trading in international growth stocks, an index like the MSCI World Growth Index should be used as the benchmark.

5. Serving as Model Portfolios for Index Funds and ETFs

Lastly, indexes are used as model portfolios for index funds and ETFs. These investment vehicles allow investors to gain exposure to a particular index, such as the Vanguard S&P 500 ETF that seeks to replicate the S&P 500 index’s performance. There are various ways to replicate index performance, discussed in the CFA Level 2 Portfolio Management section.

Besides index funds and ETFs, there are index mutual funds and private portfolios structured to match an index’s return as well.