LM02 Security Market Indexes

Part 3

5. Uses of Market Indexes

Security indexes serve the following purpose:

• Index performance serves as a proxy of market sentiment.
• Investment management performance can be better evaluated in comparison with a suitable index that serves as a benchmark.
• Serves as a proxy for measuring and modeling returns, systematic risk, and risk-adjusted performance.
• Serves as a proxy for asset class performance in asset allocation models.
• Useful in creation of passive portfolios that track index funds and ETFs.

6. Equity Indexes

Equity indexes can be classified into:

Broad market index

• Provides a proxy for the overall market performance.
• Typically, 90% of the securities in the market are represented in the index.
• Example: Wilshire 5000 index

Multi-market index

• Constructed from several indexes of different countries.
• Countries included can be based on national markets, geographic region (Latin America index), development groups (emerging market index), etc.

Sector index

• Constructed to track performance of a specific economic sector such as finance, technology, energy, health care, etc., or on a national or global basis.

Style index

Constructed to track performance of securities that are classified based on characteristics like:

• Market capitalization: Securities are classified based on market capitalization to form indexes like large-cap, mid-cap, and small-cap indexes.
• Value/Growth: Includes securities based on value/growth criteria to form growth and value indexes. (uses price-to-earnings and dividend yields to classify securities)
• Combination of market capitalization and value/growth: Includes these combinations: Large-cap value, large-cap growth, mid-cap value, mid-cap growth, small-cap value, small-cap growth indexes.

7. Fixed-Income Indexes

7.1 Construction

Compared to equity indexes, fixed-income indexes are difficult to construct and replicate. They are challenging to construct because:

• There are a large number and variety of fixed-income securities ranging from zero coupon bonds to callable and putable bonds. Pricing data is not always available.
• Many fixed-income securities are not liquid, i.e., not easy to replicate.

7.2 Types of Fixed-Income Indexes

Like equities, fixed-income securities can be classified based on the issuer, geographic region, maturity, type of issuer, market sector, style, credit quality, currency of payments, etc. The following table illustrates how the fixed-income securities can be organized based on various dimensions.

8. Indexes for Alternative Investments

8.1 Commodity indexes

Commodity indexes consist of futures contracts on one or more commodities such as agricultural products (like wheat and sugar), precious metals (like gold), and energy (like crude oil). It is important to recognize the following points related to commodity indexes:

• Since commodity indexes are based on futures indexes, the performance of the index and the underlying commodities can be different.
• It is common to have multiple indexes with the same commodities but in different proportions or weights. For example, while one commodity index may have a higher weight for energy, the other may be overweight on agricultural products. This also leads to a different risk-return profile.

8.2 Real Estate Investment Trust Indexes

Real estate indexes represent markets for real estate securities (such as REITs) and the market for actual real estate. Examples of actual real estate investments include properties such as apartment buildings, retail malls, office buildings, etc. Real estate is a highly illiquid market with few transactions and non-transparent pricing. There are several types of real estate indexes: appraisal indexes, repeat sales indexes, and REIT indexes. This material is covered in detail under alternative investments.

8.3 Hedge Fund Indexes

Hedge fund indexes reflect the returns on hedge funds. Research organizations collect data on hedge fund returns and compile this information into indexes. Since hedge funds are not required by regulation to report their performance, the research firms rely on voluntary cooperation of hedge funds to report returns. Here are some important points to consider when evaluating hedge fund indexes:

• Constituents determine the index.
• Poorly performing hedge funds are less likely to report.
• Returns of hedge fund indexes are likely to be overstated/biased upward due to survivorship bias.

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