Financial Market Indices: Facilitating Innovation, Monitoring Markets

While the advent of the modern stock market index is usually traced to the creation of the Dow Jones Industrial Average in 1896, it was the pioneering asset pricing work of Harry Markowitz, who introduced Modern Portfolio Theory in the 1950's, and William Sharpe's development of the Capital Asset Pricing Model in the 1960's which formed the intellectual basis for 'investing in market indices'. Their analysis advocated two-fund separation whereby investors should only consider risk-free investing together with the (efficient) market portfolio; attitudes to risk determined the desired percentages in each category. Subsequently Burton Malkiel and Charles Ellis each wrote forcefully about the case for investing in accordance with financial market indices as an alternative to chasing superior returns by trying to pick the winning funds of active fund managers.

intellectual firepower led to an investment revolution which offered a new way of investing for both institutional and retail investors. The first institutional index funds were created in 1973, closely followed in 1976 by the first index mutual fund. These important developments were complimented in 1989 with the creation of the first Exchange Traded Fund (ETF). ETFs offer a particularly convenient way to invest in financial market indices. This led to the first US ETF in 1993, and the first one in Europe in 2003. Meanwhile 2002 saw the creation of the first index-based ETF investing in bonds. ETFs based upon financial market indices has allowed investors to access many asset classes and markets that traditionally were only accessible to institutional investors. Additionally, many of these markets, such as, fixed income, currencies, and commodities have given investors the convenience of exchange liquidity, regulation, and transparency to asset classes traditionally only available via over-the-counter markets that are inaccessible for most retail investors.

Another particular benefit to investors of such financial market indices has been the linkage with financial derivative contracts. The broad-based nature of financial market indices has been the main reason why investors have been able to harness derivative products such as futures and options to: manage financial risks efficiently; lower transactions costs; and to achieve better risk-adjusted returns.

All of these important financial market developments and innovations, along with others, required the existence of financial market indices produced by benchmark administrators that were (and are) independent from the investment process itself.

In this brief paper we explain how and why investors use financial market indices and, in so doing, tell the story of this investment revolution. In particular we explain how, via the products created by asset managers, investors benefit from the very competitive index industry which produces a wide range of indices for asset classes with different compositions. The very wide array of competing indices produced by independent benchmark administrators gives investors the opportunity to choose the index that suits them. Anything that might reduce the competition between benchmark administrators would be at the expense of investor choice.

The paper is available for download at the link below.

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