It is hard to believe, but equity indexes (and futures and options based on them) became a commonly used investment tool only 25 or so years ago. As more and more investors began to apply indexes to their strategies, the demand grew for more indexed products. Exchanges and index providers obliged by creating hundreds of new ones, and thousands of variations on them.
Now that indexes are widely used to create derivatives, it’s useful to recall how they came about. The main factors in this story are innovation, perseverance and success breeding success.
By 1997, when Dow Jones Indexes became a business unit of Dow Jones & Co., other index providers already were established in derivatives. But Dow had the best-known index in the world, the Dow Jones Industrial Average. Dow signed three licenses that year, one for futures on the Chicago Board of Trade, one for options on Chicago Board Options Exchange and an exchange-traded fund on the American Stock Exchange. With this “can’t miss” strategy, Dow waited for success to roll in.
And waited...and waited.
You know the famous Thomas Edison quote about success being “1% inspiration and 99% perspiration?” Well, try waiting out a “can’t lose” formula to the sound of silence. There was a lot of “99%” around the shop.
The issue, as it often is with new futures and options contracts, was liquidity. The Dow futures did not have enough of it and the big players were passing it by for easier-to-trade alternatives. This is where innovation and perseverance came in. The CBOT folks had an idea: Why not create an additional, modestly sized futures contract that would appeal to smaller institutions and individuals?
The Chicago Mercantile Exchange had already had success with its E-mini S&P contract but amid a historic bull market, finding the right multiplier was a difficult task. If the original $10 Dow contract was too large and the original $2 mini Dow was too small, the next attempt hit the mark.
So, Dow adjusted expectations and the CBOT $5 mini-sized Dow was launched. It was a big hit, and trading volume and open interest started climbing. Before long, the bigger players took notice and were drawn to the newly created liquidity they demanded. Dow learned that success doesn’t always materialize in the form first envisioned, a lesson that has served it well for more than a decade.
The success of the mini-sized Dow helped not only to increase interest in these two products, it also boosted the Dow Jones Indexes name so that our subsequent indexes received serious attention.
Nowadays, whenever an asset class or trading vehicle gains visibility and popularity, such as real estate or emissions trading, there are soon indexes ready to help measure and monitor them. The concept of benchmarking is well-entrenched in the psyches of investors of all sizes. No matter what the topic of investment interest, players need to know if their investment strategies are working.
VOLATILITY
Usually these measuring sticks come from independent index providers. But in the case of volatility, it was CBOE that led the innovation initiative to first conceive the index and then convert it into a tradable instrument. CBOE’s volatility indexes, first introduced in 1993, measure market expectations of 30-day volatility implicit in the prices of near-term index options.
Volatility indexes remained purely informational until 2004, when futures were listed on VIX, the symbol for volatility on the S&P 500, though the original index was based on options on the OEX, S&P 100. Options were introduced in 2006 and in the first full year of trading became CBOE’s second-busiest cash-settled index option with an average daily volume of more than 93,000 contracts. CBOE currently publishes data on nine other equity-related volatility benchmarks and strategies, and recently expanded into creating benchmarks that measure expected volatility in various commodities and the value of the euro.
Meanwhile, public pension plans began converting some or all of their investment strategies to indexing as the active managers they hired failed to earn their keep by producing above-market returns. By hitching pension dollars to an index, pension trustees (who shoulder fiduciary responsibility) know that they will not fall behind the greater market since indexes track the market; with passive investing, they give up the chance of outperforming the market in return for assurance of not ever underperforming. Equally as important to the trustees, indexing is cheap. Without the expensive tab for active management (and research and analysis to support it), more money stays with pensioners.
SECTOR INDEXES
As pension plans and other institutional investors stepped up their use of indexes, an interesting development occurred. Clients asked index providers to create more products — and not just to cover broad markets. They wanted to follow individual segments of their enormous portfolios, such as growth and value, specific industries (health care, technology, etc.) and sectors such as insurance and biotech.
The index providers responded with an outpouring of indexes that took observers’ breath away. Then they started moving one step ahead. Stand-alone indexes and even entire index families began being developed before clients asked for them. Every conceivable slice of the market got its own index and a flood of products (mainly ETFs but also some options and futures) followed. Today, Dow Jones computes more than 130,000 indexes every trading day. Last year, it launched an average of one new index or index family a week.
Many of them require creativity to work out methodologies that, in some cases, are intended to track investment strategies or approaches, rather than market segments. In 1999, when Dow launched the first Islamic market indexes, it might have hoped for, but didn’t predict, the explosive growth of the Shariah-compliant market. Today, more than $7 billion tracks the Dow Jones Islamic Market indexes. Alas, there aren’t any futures or options listed on them yet.
Developing indexes is easy compared to establishing a market. It can take years before an index, no matter how innovative, attracts sufficient followers that a futures and options market can be built around it. Unlike the ETF market, which has seen exponential growth, derivative markets are too expensive to be created without the firm knowledge there will be real buyers and sellers ready to trade.
VIX is an example of this, with a decade between index debut and product launch. Another is the expected introduction this fall of futures contracts on the Dow Jones Sustainability World and North America Indexes at the Chicago Climate Exchange (CCX). These indexes track corporate sustainability leaders based on social, environmental and economic criteria. (Dow Jones also teamed with CCX to create a family of global emissions indexes.)
The world sustainability index was created in 1999 but only now is getting futures contracts. Why? Because “going green” has expanded from the niche passion of some Europeans into the mainstream U.S. consciousness, thanks in no small part to soaring fuel prices. It took this long for the appetite of derivatives’ traders for sustainability-based investment vehicles to become big enough to create a market for them.
With markets becoming more and more linked around the globe, the derivatives traders providing liquidity to a market can be located anywhere. That’s a major factor in the rousing success of STOXX Ltd., the joint venture between Dow Jones Indexes, the Swiss Exchange and Deutsche Bourse that is celebrating its 10th anniversary this year. In this case, the derivatives contracts were launched shortly after the indexes because both were tied to the Jan. 1, 1998, advent of the euro.
The Dow Jones EURO STOXX 50 futures and options contracts, listed at Eurex, is one of the most liquid indexes in the world. They are rivaled only by derivatives on the S&P 500, DAX, Russell 2000 and Nasdaq 100. Options and futures on Kospi, the Korean index, have tremendous volume but much less open interest.
According to Eurex, about 18% of the futures volume in the Dow Jones EURO STOXX 50 comes from trading terminals in the United States. A similar figure for options trading isn’t available because the Securities and Exchange Commission does not allow U.S.-located terminals to trade directly with Eurex. Option-trade orders are known to be routed through European branches of U.S. firms, but the amount cannot be tracked.
Moreover, €23.5 billion ($34.6 billion), or 28% of all assets tied to European equity ETFs, track Dow Jones STOXX indexes. These assets are a direct contributor to the volume and open interest of the Dow Jones EURO STOXX 50 and other STOXX indexes, as the portfolio managers use futures and options in the stewardship of the ETFs. Success in one kind of indexed instrument almost always feeds success in another kind that is based on the same index.
When Dow was new in the index business, it sometimes worried that it might “over-license” the Dow or other indexes, that one product might cannibalize another and not allow either to thrive. In fact, the opposite happened. It was blessed with a “virtuous circle” in which the success of one product based on one of our many indexes cross-pollinated with other instruments (ETFs, derivatives) and actually made them stronger and more liquid.
Success bred success, in other words, but only after the innovation had blossomed and the perseverance endured. We can expect to see more of all three as we look ahead. In the index world, there seem to be more strategy indexes being developed, although occasionally there is a new asset class added to the mix (residential housing, for example). In the derivatives world, the success of VIX may inspire new ways of measuring, and perhaps someday trading, other risk factors.
John Prestbo is editor and executive director of Dow Jones Indexes. He oversees new index development, the production of existing indexes, public relations and research.
