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 ETFs have been constructed based on the S&P 500 Index. Academics and analysts use the S&P 500 as the proxy to perform various statistical research on stock market behavioral patterns.

Breaking Down Market Proxy

The S&P 500 Index is a broad proxy of the stock market based on a market capitalization of the 500 largest companies traded on the NYSE and Nasdaq stock exchange. Most agree that it is a better proxy than the Dow Jones Industrial Average (DJIA), which arbitrarily uses nominal share prices to calculate the index value. This price-weighted index 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. 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 the bond market. Utility and consumer staples stocks, in particular, since they pay consistent and safe dividends, are believed to be close in nature to bonds, which provide coupon yield.

Significance of a Market Proxy

There has been a mass migration of investor money from actively managed funds to passive funds in recent years. Vanguard, BlackRock and State Street have built AUM empires on 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, small-cap stocks and so on.

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, how will passive funds perform relative to actively-managed funds that have the flexibility to respond to changing market conditions and invest in assets not tied to the S&P 500 Index or other market proxies?