Some of the major uses of indexes include:
- gauges of market sentiment;
- proxies for measuring and modelling returns, systematic risk, and risk-adjusted performance;
- proxies for asset classes in asset allocation models;
- benchmarks for actively managed portfolios; and
- model portfolios for such investment products as index funds and exchange-traded funds (ETFs).
Gauges of Market Sentiment
The original purpose of stock market indexes was to provide a gauge of investor confidence or market sentiment. As indicators of the collective opinion of market participants, indexes reflect investor attitudes and behaviour.
Proxies for Measuring and Modelling Returns, Systematic Risk, and Risk-Adjusted Performance
The capital asset pricing model (CAPM) defines beta as the systematic risk of a security with respect to the entire market. The market portfolio in the CAPM consists of all risky securities. To represent the performance of the market portfolio, investors use a broad index.
Proxies for Asset Classes in Asset Allocation Models
Because indexes exhibit the risk and return profiles of select groups of securities, they play a critical role as proxies for asset classes in asset allocation models. They provide the historical data used to model the risks and returns of different asset classes.
Benchmarks for Actively Managed Portfolios
Investors often use indexes as benchmarks to evaluate the performance of active portfolio managers. The index selected as the benchmark should reflect the investment strategy used by the manager.
Model Portfolios for Investment Products
Indexes also serve as the basis for the development of new investment products. Using indexes as benchmarks for actively managed portfolios has led some investors to conclude that they should invest in the benchmarks instead. Based on the CAPM’s conclusion that investors should hold the market portfolio, broad market index funds have been developed to function as proxies for the market portfolio.
