All major asset classes except for cash, Treasuries and gold experienced steep sell-offs in 2008, the initial phase of the financial crisis. As many actively managed strategies struggled to match their benchmarks, investors gained new appreciation for two benefits of index-linked investments: lower costs and the relative predictability of returns that track their respective indexes.
The concept of a stock index is hardly new. The Dow Jones Industrial Average, launched in 1896, is one of the world's most-recognized equity index. Indexes have moved beyond the 12 stocks that made up the initial Dow and have proliferated, becoming more varied and sophisticated in recent years. The venerable Dow has been joined by 130,000 Dow Jones equity indexes, as well as fixed-income and alternative asset indexes. Standard & Poor's 300 or so-called "headline indexes" include the global benchmark S&P 500 Index. NASDAQ OMX offers 1,500 indexes, fueling 1,800 index-based products, which are traded in 37 countries.
"Indexing now covers the spectrum of asset classes, rather than primarily being an equity-based strategy for institutional and individual investors," says Michael Petronella, president designate of CME Group Index Services LLC. "Additionally, investment vehicles, such as exchange traded funds, have been the accelerator of growth over the past decade, particularly outside the United States. More recently, the financial crisis has driven interest because it hurt passive investors less than active investors. Research has shown that index investing offers lower costs and outperforms active management over time."
Flagship indexes
The "efficient market hypothesis" was the basis for the first index-based mutual funds in the 1970s. It holds that new information about companies is so rapidly incorporated into their stock prices that active investors cannot count on beating the market over the long term, especially after factoring in investment costs. Economists continue to argue about how rational the markets really are. However, it is hard to disagree that this hypothesis has led to numerous successful indexes and products, including:
- The S&P 500 Index. More than $3.5 trillion in investment assets are benchmarked to the S&P 500, more than any other index in the world. E-mini S&P 500 futures are the world's most actively traded stock index futures contracts, trading more than 2.3 million contracts on average per day in 2009.
- The NASDAQ-100 Index. More than $400 billion in global assets are linked to the NASDAQ-100 index. Futures contracts based on the NASDAQ-100 have traded more than 600 million contracts exceeding $25 trillion in notional value since their introduction in 1996.
New roles for an old strategy
While traders may be most familiar with equity-based indexes, much of the recent action has been in alternative asset classes, such as commodity futures. Since futures have historically performed quite differently than stocks or bonds, incorporating commodity index futures into a diversified stock and bond portfolio may improve the portfolio's overall risk and return. Commodity indexes are also used as a hedge against inflation risk, since commodity prices generally rise with inflation.
The rising number of indexes means there is a product for virtually every trading need. At CME Group alone, customers have access to 48 equity index futures and options contracts, S&P GSCI futures and options and excess return futures, the Dow Jones-UBS commodity index futures, Dow Jones-CBOT Treasury Index futures, and the S&P/Case-Shiller Home Price Index futures.
A look into the future
While new indexes can be based on a relatively small number of components - such as a handful of stocks - index-based financial products must be widely relevant as investments, arbitrage or hedging vehicles. However, experts believe indexes will continue their explosive growth due to their potential to enhance investment performance, reduce costs and help manage risks.
"Given the unlimited ingenuity we've seen in researching, designing and using indexes as benchmarks and investment products, I don't think we'll run out of new ideas for indexes anytime soon," says Dr. David Blitzer, Standard & Poor's managing director and chairman of the company's index committee. "Green indexes, high dividend-paying stock indexes, indexes based on different ways to weight component stocks. At S&P, we even have indexes that track the costs of borrowing to short stocks in the S&P 500, S&P Mid-Cap 400 and S&P Small-Cap 600."
"We see two major areas for indexed product growth: geographic and sector-based," says John Jacobs, chief marketing officer of NASDAQ OMX and executive vice president of the exchange's global index group. "We haven't touched much of the globe with indexed products. In fact, the first fund based on the NASDAQ-100 was just introduced in China. And there are entire sectors that don't have a proper index.
For example, we'll be able to create rules-based indexes around the swaps market assuming the trend continues toward greater transparency and consistency, as swaps move from the over-the-counter markets to a central clearinghouse. "Looking forward, we expect a long future of growth for index-based financial products," he says.
Indexing Innovation
A wealth of investment data. A global customer base hungry for new products. And a shared interest in creating and licensing new indexes for use as benchmarks and as the basis of investment products. Those are three reasons that CME Group and Dow Jones launched a joint venture company in March 2010.
The new firm, CME Group Index Services LLC., will own and continue doing business as Dow Jones Indexes. The company is best-known for the Dow Jones Industrial Average, which was first licensed in 1997 as the basis for investment products. Today, Dow Jones Indexes offer more than 130,000 equity indexes as well as fixed-income and alternative indexes, including measures of hedge funds, commodities and real estate.
The proverbial "more" is to come.
"The data provided by CME Group Index Services offers a rich opportunity set," Michael Petronella, president designate, CME Group Index Services LLC., says. "We look forward to bringing new products to CME Group's global customer base. In addition, we'll continue working with clients and other exchanges to develop, customize and license indexes in a variety of asset classes, including exchange traded funds, over-the-counter and structured products."
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