What Is a Market Proxy?

What Is a Market Proxy?

A market proxy is a broad representation of the overall stock market. A market proxy can serve as the basis for an index fund or statistical studies. The S&P 500 index is the best-known market proxy for the U.S. stock market. Index funds and exchange traded funds (ETFs) have been constructed to include all, or a portion, of the stocks in the S&P 500 index. Investors and analysts use the price moves in the S&P 500 as the proxy to perform various statistical research on stock market behavioral patterns.

Understanding a Market Proxy

The S&P 500 index is a broad proxy of the stock market based on a market capitalization of 500 large companies traded on the New York Stock Exchange (NYSE) and Nasdaq stock exchange. Market capitalization–or market cap for short–multiplies the company's stock price by its outstanding equity shares. The market cap weighting of the S&P 500 tends to favor larger companies since they have more shares outstanding. As a result, the price moves of the larger companies tend to have a greater impact on the value of the index as compared to the smaller market cap companies.

Most agree that the S&P is a better proxy than the Dow Jones Industrial Average (DJIA), which arbitrarily uses nominal share prices to calculate the index value. The Dow's price-weighted formula gives companies with higher share prices greater weight in the index, regardless of their importance in representing the relative industry standing in the economy. Standard & Poor's Financial Services controls the composition of the DJIA Index.

Bond Market Proxy

Although there is no equivalent market proxy for the bond market as comprehensive as the S&P 500 Index, informal references are made to dividend stocks being a proxy for bonds. Dividends are cash outlays to investors by corporations as a reward for owning the company's stock. Utility stocks, which include the gas and electric companies, usually pay consistent dividends. Also, consumer staples stocks, which sell essential goods, are a safe bet for dividend payments. Both utilities and consumer staples are believed to be close in nature to bonds, which pay interest via a coupon rate.

However, certain bonds, such as U.S. Treasuries, are backed by the U.S. Treasury Department, meaning investors won't lose their initial investment called the principal. Conversely, stocks, including utility and consumer staples, are not guaranteed by the government and investors can potentially lose part or all of their investment.

Popularity of Market Proxy Funds

Index funds, many of which are essentially market proxies of the S&P 500, have grown in popularity due to their low fees. Index funds are not actively managed by an investment portfolio manager, meaning stocks are not being bought and sold in and out of the fund. Over the years investors have opted for these passively-managed funds, which include Vanguard, BlackRock, and State Street.

These funds have created passive vehicles based on the S&P 500 index and many other proxies representing the international stock market, the global stock market (U.S. + international), and segments of the stock market such as large-capitalization stocks, medium-cap stocks, and small-cap stocks.

Indexed products have historically outperformed actively-managed funds, but there is a growing debate about whether they have become too large to serve the needs of investors effectively. In the event of heavy or sustained market downturns, for instance, there's a concern of how well passive funds will perform relative to actively-managed funds that have the flexibility to respond to changing market conditions.