Despite near record low volatility in equities, demand for derivatives on equity indexes continues to grow as more capital is benchmarked to indexes. “We saw volume in stock trading and stock index trading decline in a bear market, which was no surprise, everyone was ticked-off at the stock market,” says David Blitzer, managing director and chairman of the indexing committee at Standard and Poor’s. And yet despite declining volume and volatility on the underlying indexes, futures on these same equity indexes set new records for volume and open interest.
At the highest level, indexes are intended to lower costs and broaden exposure to a variety of underlying investing instruments, and historically speaking they have succeeded wildly and there has been a commensurate proliferation of indexes. There are sector indexes, narrow indexes and broad based indexes, which include hundreds and even thousands of equities. There are large cap indexes, mid cap indexes, small cap indexes, and specialized indexes that include growth stocks, value stocks and any number of combinations of the above. They are all intended to offer immediate, economical exposure to a target sector.
A star is born
“In the beginning, there was Dow,” says John Prestbo, markets editor for The Wall Street Journal and editor of the Dow Jones Indexes. Charles Dow, the father of equity indexes, created the Dow Industrial Average (DJIA) in 1896. The index includes only 30 of the largest and most important companies based in the United States and is weighted by price. It was, and is today, intended to serve as a “stick in the sand,” from which to determine whether the tide of the stock market is rising or falling, Prestbo says.
Since then the value of indexing has been proven through time and indexing has been applied not only to equities, but also to currencies, commodities and other investment instruments, driving down costs and simplifying the process of diversifying portfolios. “Indexes are important in the equities world, especially in the U.S. market, because you have so many different equities,” says Rick Redding, managing director of products and services at the Chicago Mercantile Exchange (CME). He adds there are only a handful of stocks that are so liquid as to not require effort to find the other side of the trade. And rather than having to purchase hundreds or even thousands of stocks, indexes provide a way to instantly take on or take off broad market exposure.
“The idea of having to buy 500 stocks was kind of a staggering thing,” Blitzer says, adding the S&P 500 was constructed to reflect and represent the entire U.S. stock market. It is weighted based on market capitalization and provides one of the cheapest and easiest ways to achieve diversification. “The idea that you could take a long or a short position in the U.S. stock market with a single trade resonated with traders and has resulted in spectacular growth for the index and its derivatives,” Blitzer says.
As the equity bull market hit its stride in the 1980s and 1990s, mutual fund managers benchmarked themselves to broad market indexes. Their goal was to match or beat these broad indexes under the belief the market always appreciated through time. This created new hedging demand for indexes. As the bull market hit overdrive in the second half of the 1990s and managers consistently missed their benchmarks, investments in index funds exploded. Why pay more for active management? “On average, the S&P 500 will outperform 60% of the active managers. The expenses are lower too,” Blitzer says.
Champagne supernova
The idea of a futures contract on a stock index is a relatively new one, dating back only to 1982 when futures on the Value Line Composite index were launched on the Kansas City Board of Trade. It was followed just months later by the CME’s futures contract on the S&P 500.
“At first everyone thought of them as another off-track betting way of speculating on the stock market but with leverage,” Prestbo says. But the timing was right. “It came at the same time as brokerage commissions were being squeezed down and futures on equity indexes were a way money managers survived. By using indexes they offset the loss of commissions by investing less in the research. Plus, managers could hedge positions in the equity markets and ‘equitize’ large inflows of cash by buying futures contracts and parking the rest in Treasury bills while they researched the actual stocks they wanted to buy,” he says.
Indexes vs. Commodities
The difference between a futures contract on a commodity and a stock index is minimal and largely conceptual. But Prestbo says the index is simpler. “If you are dealing with wheat, you’ve got to specify what kind of wheat. You’ve got to specify all kind of things about the quality of the grain. You’ve got to specify all kinds of things about where and when it’s delivered. All of that kind of stuff has to be delineated in the contract that you’re trading. With an index all you have to do is specify, ‘deliver in cash the value of this index times the multiplier, etc., etc.’ So the index becomes the specification of the contract. But otherwise they are the same.”
The move towards indexation has hit the commodity space. With the end of the long equity bull market in 2000 and subsequent rise of a commodity bull market, institutional investors are applying the lesson they learned in the 1990s and investing in passive commodity indexes. At last count $60 billion are benchmarked to various commodity indexes. While that hasn’t translated into increased volume on futures on those indexes, it could as the market increases.
Weighting
One of the primary differentiators in the many different indexes is the method by which they are weighted. “By and large in equity, market capitalization weighting indexes are still the mainstream and everything else is a departure from that,” Prestbo says. The Dow Jones Industrial Average is constructed based on a simple arithmetic average of the stock price of each of the 30 large cap, blue chip component stocks.
The S&P 500 is the first index weighted based on market capitalization. The market capitalization of the 500 component stocks total roughly $11 trillion and belong to the following ‘constituencies’: Energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, telecommunications and utilities. The price movement of each stock is reflected as a percentage of the whole index. As a result, companies with larger market caps push or pull the index more so than companies with smaller market caps.
There are many other sorts of weighting schemes used to construct indexes. For example, the U.S. dollar index is geometrically weighted and predicated on the trade weighted average of the dollar against six currencies (see “U.S. dollar index,” below). The movement on an index based on geometric weighting is indicated as a percentage change from a predetermined point.
U.S. dollar index
The USDX uses a geometric weighting scheme; each component reflects a specified percentage of the index.
Euro57.60%
Japanese yen13.60%
British Pound Sterling11.90%
Canadian dollar9.10%
Swedish kroner4.20%
Swiss franc3.60%
This isn’t an issue for the buyer, but if you short a geometrically weighted index, you need to be aware that you are selling it at a fixed component exposure. For example, if you bought the index at 100 and sold at 200, you have doubled your money. However, if you sold the index and were hedged in the components and the index doubled, the notional value of 57.6% of 200 is 115.2.
Prestbo concludes, “Indexes are a key element in the democratization of investing,” adding that indexes and futures on the indexes have proven themselves. “Without them, it would all be less successful and more expensive than it is today. It’s through indexes that Mom and Dad, Joe and Betty, come to understand what is happening in the investment world.”
