Exploring the Uses of Market Indexes | CFA Level I Equity Investments
Welcome back! In this lesson, we’ll dive into the uses of market indexes, making it engaging and enjoyable. So, let’s jump right in!
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.
And there you have it – the 5 common uses of market indexes! Stay tuned as we delve deeper into equity indexes in the next lesson. Don’t go away!