Uses of security indices:
1. Gauging market sentiment: Indices were originally set to reflect the mood of investors.
2. Benchmarking for fund managers: Indices are used as a benchmark against which an active fund manager’s performance can be measured. But here the index selection should be in line with the manager’s investment style. For example performance of a manager investing in small market capitalization stocks should be evaluated against an index comprising small cap stocks and not large cap stocks.
3. Estimating beta and risk-adjusted return: In Capital Asset Pricing Model, two key variables are beta (systemic risk of a security with respect to the market) and the expected return of the security. Index returns are used as a proxy for both these measures – security’s actual returns are compared to index returns to estimate risk-adjusted return.
4. Proxy for asset classes: In asset allocation exercises, historical returns of an index form the basis of expected return and standard deviation for the asset class the index closely represents.
5. Model portfolio for investment products: Increasingly, investors are selling products that mimic established indices. Such an approach leads to lower costs, as no active management is required. For e.g. exchange traded funds or ETFs are a popular investment vehicle for investors who want risk and return exactly in line with a particular index.
Check your concepts:
(46.9) Which of the following is least likely to be a use of security market indices?
(a) Calculating beta and actual return of the security
(b) Benchmarking according to the manager's investment style
(c) Used as a proxy for asset classes for asset allocation
Solutions:
(46.9) Correct Answer is A: The indices are used for calculating beta and the expected return of the security and not the actual return of the security. We don't require indices to calculate the actual return of the security.
