Product development in the age of indexing

Futures, Oct 2008 by Prestbo, John A

Revolutionary changes have occurred throughout the futures and derivatives industry and one important aspect has been in product development generally and indexing in particular.

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 equityrelated 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 abovemarket 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.