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Explain what security market indexes are used for

CFA® Level I · Equities · Equity Issuance and Trading · EQ.3.d

The idea

Indexes serve as gauges of market sentiment, as proxies for measuring and modelling returns, as proxies for systematic risk in asset pricing models, as benchmarks for active managers, as the basis for asset allocation models, and as the underlying for index funds and derivatives. The uses conflict: an index that is a good sentiment gauge may be a poor benchmark, and a benchmark must be investable, unambiguous and specified in advance - conditions many published indexes do not meet. Choosing an index because it is familiar rather than because it matches the mandate is a common and costly error.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which is a recognised use of a security market index?

  1. Serving as a benchmark against which active managers are measured - correct
  2. Determining the dividend policy of constituent companiesWhy not: A board sets its own dividend. Index membership has no bearing on it.
  3. Setting the risk-free rateWhy not: The risk-free rate comes from government securities. An equity index proxies the market portfolio, which is the risky side of the model.

A market index is a measuring stick for a group of securities. One of its main uses is as a benchmark, the standard used to judge whether an active manager did well. Other uses include showing market sentiment, helping to measure risk, and providing the basis for index funds and derivatives. It does not set a company's dividend or the risk-free rate.

A harder one

What must be true of an index for it to serve as a valid benchmark?

  1. Coverage of at least five hundred securitiesWhy not: No count makes a benchmark valid. A narrow index can be a fine benchmark for a narrow mandate.
  2. Investable, unambiguous and set in advance - correct
  3. Weights based on market capitalisationWhy not: Any weighting can serve, so long as the result is investable, unambiguous and agreed beforehand.

A benchmark is the standard a manager is judged against, so it must be fair. That means three things. It must be investable, so the manager could actually hold it. It must be unambiguous, so anyone can work out what is in it. It must be specified in advance, so it cannot be picked after the results are known to flatter or punish. The number of securities and the weighting method matter much less.

The hardest tier

A small-cap value manager is measured against a broad large-cap index. What does the result mostly reflect?

  1. The manager's security selection skillWhy not: Whatever selection added is buried under the difference between two market segments the manager never chose.
  2. The difference between two market segments - correct
  3. The manager's trading costsWhy not: Trading costs are real but small next to a style gap that can run to double digits in a year.

Small-cap value managers buy small, lower-priced companies. A broad large-cap index holds mainly large companies. The two segments can perform very differently. Idea: Measured result = Manager's skill + Difference between segments. Here the second part dominates, so the result mostly shows how small-cap value did against large-cap, not the manager's skill in picking securities. For example, if small-cap value beats the index by 4% only because that segment had a good year, the manager looks skilled with no skill at all. A benchmark should match the mandate.

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