Investment
Management UNIT 4 – MARKET INDICES
Source Material
Reilly, F. K. & Brown, K.C. (2003). Investment Analysis, Portfolio
Management. 7th Ed. South Western Publishing
Market Indices
If an investor owns more than a few stocks or bonds, it is cumbersome to
follow each stock or bond individually to determine the composite
performance of the portfolio.
Also, there is an intuitive notion that most individual stocks or bonds move
with the aggregate market.
Therefore, if the ov erall market rose, an individual’s portfolio probably also increased in v alue.
Indexes are useful in assessing investment results.
They provide a benchmark against which performance can be compared.
They are also useful in financial research, through which an investigator seeks to discover the relationship between certain economic v ariables and market results.
Uses of Security Market Indexes
A benchmark to evaluate the performance of professional money managers
A primary application is to use the index values to compute total returns and risk for an aggregate market or some component of a market, over a specified time period,
and use the rates of return and risk measures computed as a benchmark to judge the performance of individual portfolios.
A basic assumption when evaluating portfolio performance is that any investor should be able to experience a risk-adjusted rate of return comparable to the market
by randomly selecting a large number of stocks or bonds from the total market;
Hence, a superior portfolio manager should consistently do better than the market.
Therefore, an aggregate stock or bond market index can be used as a benchmark to judge the performance of professional money managers.
Uses of Security Market Indexes
To Create and Monitor an Index Funds:
Indicator series are also used to develop an index portfolio.
It is difficult for most money managers to consistently outperform specified
market indexes on a risk adjusted basis over time.
If this is true, an obvious alternative is to invest in a portfolio that will emulate the market portfolio.
This notion led to the creation of index funds, whose purpose is to track the performance of the specified market series (index) over time.
The original index fund concept was related to common stocks.
Subsequently, development of comprehensive well specified bond
market indexes and similar inferior performance relative to the bond
market by most bond portfolio managers have led to a similar
phenomenon in the fixed-income area (bond index funds).
Uses of Security Market Indexes
To measure market rates of return in economic
studies:
Securities analysts, portfolio managers, and
others use security market indexes to examine
the factors that influence aggregate security
price movements
T hat is, the indexes are used to measure aggregate market movements.
Uses of Security Market Indexes
For predicting future market movements by technicians:
Another group interested in an aggregate market series is
“technicians,” who believe past price changes can be used
to predict future price movements.
For example, to project future stock price movements,
technicians would plot and analyze price and volume
changes for a stock market series like the Dow Jones Industrial
Average.
Uses of Security Market Indexes
As a proxy for the market portfolio of risky assets when
calculating the systematic risk of an asset
Works in portfolio and capital market theory have
implied that the relevant risk for any individual risky asset
is its systematic risk
which is the relationship between the rates of return for a risky asset and the rates of return for a market portfolio of risky assets.
Therefore, in this case, an aggregate market index is
used as a proxy for the market portfolio of risky assets.
Differentiating factors in Constructing Market Indices
Because the indicator series are intended to reflect the
overall movements of a group of securities, it is necessary to
consider which factors are important when constructing an
index that is intended to represent a total population.
The following factors are important:
The Sample
Weighting Sample Members