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Explain what security market indexes are used for

CFA® Level I · Equity Investments · 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.

Benchmarking is one of several uses, alongside sentiment measurement, risk modelling and providing the basis for index funds and derivatives.

A harder one

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

  1. It must contain 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 specified in advance — correct
  3. It must be capitalisation weightedWhy not: Any weighting can serve, so long as the result is investable, unambiguous and agreed beforehand.

A benchmark chosen after the fact, or one that cannot be held, cannot discipline a manager's performance. Size and weighting are secondary to those conditions.

The hardest tier

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

  1. The manager's security selection skillWhy not: Selection is swamped here by the gap between two different market segments, which the benchmark choice imposed rather than the manager.
  2. The manager's ability to control costsWhy not: Costs move a return by tens of basis points. A style mismatch moves it by whole percentage points.
  3. The gap between the two market segments — correct

That difference is one the manager did not choose. A benchmark mismatch attributes a style's performance to the individual: the manager looks brilliant or hopeless according to which segment is in favour, and neither conclusion is about them.

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