Chapter: 6
INDICES AND ETPs
In this chapter we’ll answer the question: “What are the different types of stock indices and etf’s?”.
We’ll show you the difference between the cap-weighted index, price-weighted index, and equal-weighted index as well as how etf’s work.
Let’s get started.
INDICES
Stock indices are portfolios of multiple individual companies. Broad-based indices such as the S&P 500 are useful measures of market risk. Sector indices such as the CYC ( cyclical index) provide exposure to a specific subset of the market. Indices can also differ in the way that the individual stocks in the basket are weighted.
Capitalization-Weighted Index
- Most common type of index weighting.
- Weights of individual components according to their market capitalization.
• Example: S&P 500 and Eurostoxx - The index weights are adjusted whenever a company issues or retires shares. Stock splits/stock dividends do not impact the index weights as the adjustment on the price is offset by an adjustment to the shares.
Price-Weighted Index
- Each name has an equal number of shares in the index (as opposed to an equal number of dollars).
- Adjustments to the index weights happen whenever there is a stock split/stock dividend.
- Not common but two major examples are D)IA and Nikkei 225.
Equal-Weighted Index
- Each index member represents an equal number of dollars in the basket.
- Equal emphasis to the price movements of all the stocks measured.
- Example: NASDAQ-1 00 equal weighted index (NDXE)
- The index weights will deviate from equal weighting as the prices of each stock move, so the indices need to be rebalanced back to equal weighting on a periodic basis.
In the United States there are a number of different indices. These are the most widely followed. All have liquid derivatives markets including futures, options and ETFs.
Major US Indices
S&PS00
- Capitalization-weighted Index of 500 stocks intended to be a representative sample of leading companies in leading industries within US.
- Stocks chosen for market size, liquidity and industry group representation.
- Ticker: SPX. Market Capitalization: $12 trillion. Most liquid and efficient derivative market globally.
Dow Jones Industrial Average
- Price-weighted index of 30 “blue chip” stocks of US industrial companies.
- Includes substantial industrial companies with a history of successful growth and wide investor interest.
- Ticker: DJIA. Market Capitalization: $3.8 trillion. The DJIA is the most widely followed index outside of finance, but actually represents only a small fraction of the derivative marketplace.
Russell 200 Index
- Float-weighted index designed to measure the performance of 2,000 smallest publicly traded US companies that are included in the Russell 3000 index.
- Ticker: RUT or RTY. Market Capitalization: $1.4 trillion. Because the index contains 2,000 members of varying liquidity profiles, the derivative market including the ETFs is more efficient than the underlying basket itself.
NASDAQ 100 Index
- Modified capitalization-weighted index designed to track the performance of a market consisting of the 1 00 largest and most actively traded non-financial domestic and international securities listed on the NASDAQ stock market, based on market capitalization.
- Ticker: NDX. Market Capitalization: $4 trillion. The NDX was extremely popular during the tech bubble and the success of the ETF QQQ helped drive the current market in ETFs.
INDICES
Weight and Impact
The weight of a stock in an index is the percent contribution of that stock to the index. If the weight of ABC is 10% of an index and it is up 20%, then the index will be up 2% (10% x 20% = 2%). The dollar impact of a stock on an index is the point contribution of that stock to the index. If stock ABC has $0.50 of impact and is up $5, then the index will be up $2.50 ($0.50 x $5 = $2.50).
Weights can be found on most data services and are useful in spreadsheets or when calculating risk profiles. Impact is useful during earnings season or when the stock is halted mid-day. You can quickly do the math in your head and react quickly to changes in the market.
Market cap weighted:
weight= (market cap stock/market cap index)
impact= no. of shares outstanding/(index divisor x 1,000,000)
impact= weight x ( index price/stock price)
For the SPX, IBM has a 1.708% weight. To calculate IBM’s impact on the SPX, we look up the number of IBM shares outstanding, 1,242,000,000 shares. The SPX has a divisor of 9,093 so IBM’s impact equals
(1,242,000,000/[9,093 x 1,000,QJ0]) or about 14 cents.
Equal dollar weighted:
weight= 1 /(no. of names)
impact= index price/(stock price x no. of names)
The XNG natural gas index has 16 names. Every stock has a 6.25% weight in the index. To calculate CHK’s impact on the XNG, use the price of XNG = $626.62 and CHK = $27.65. Therefore CHK’s impact=
$626.62/($27.65 X 16) = $1.416.
Remember the weight and impact is only for the contribution of a single stock. If the movement in a single stock will encourage movement in the market as a whole, the net effect will be much greater.
Expiration and Settlement
The settlement process of options on equity indices is different from those on stocks or ETFs. Unlike most products that settle to the underlying asset, index options settle to the cash value of the difference between the settlement price and the option strike.
ETF Physical Settlement
- SPY 125 put: If the SPYs are trading $123 on expiration, the 125 puts will settle to a short position in the underlying stock as if the owner of the puts had sold stock at $125. The investor could buy back the stock for a $2 profit or maintain the short stock position.
Index Cash Settlement
- SPX 1250 put: If the SPX settles to $1,230 at the opening print on expiration, the owner of the 1250 put receives a $20 cash payment. The investor can receive $20 and choose whether to sell stock to replace the short index position.
INDICES
For example, let’s create a custom index, XYZ with 4 equal weighted stocks, A, B ,C, D.
A= $50, B = $50, C = $50, D = $50
Index XYZ = A+ B + C + D = $200
On expiration, each stock opens 1 minute apart at $51, then trades back down to $50. Until the stock opens, the index uses the prior night’s close in the stock .
The index never traded above $201, but the opening price of the Index basket equals the sum of the opening price in the stocks.
XYZ op= A op+ B op+ C op+ D op= $51 + $51 + $51 + $51 = $204
The opening price of $204 is $3 higher than the highest traded price in the index. A basket of stock executed market on open would capture this price. A basket executed live would not.
This difference of the settlement price from trading price can be offset provided the holder of the option {long or short) executes a stock basket of equivalent index exposure on the opening print. For example, imagine we are Ions the XYZ 210 put. Based on the previous close of $200, the settlement value of the put would be $10. Because settlement was $204, the puts expire worth $6. If we then replace the risk exposure by selling the basket after the open in the market, we expect to sell it at $200 for a net loss of $4. If, on the other hand, we sell the basket on the opening print at $204, then when the stocks trade back to $200 we earn back the $4 making us indifferent to the actual settlement price.
Expiration Impact on Single Stocks
Every future or option contract has both a long holder and a short holder. If these positions are not closed before expiration, both counterparties will need to execute a stock basket to replace their market risk exposure. On expiration, large amounts of stock change hands as buyers and sellers meet to offset their expiring positions. These expiration prints are particularly large on quarterly expirations when futures expire as well. In some cases, as much as $25 billion in stock will change hands at once.
If all counterparties replaced 100% of their market risk these large transactions would have no market impact. In practice, some holders will allow their derivatives to expire without trading an offsetting basket This creates a net buy or sell imbalance in many individual stocks.
Recently, many derivatives exchanges have added additional expiration periods including monthly, weekly and even daily cycles. Even if you are not trading index options it is important to be aware of expiration cycles since they may affect your ability to execute a single stock order and may make it difficult to match or outperform the VWAP (volume-weighted average price) for that day.
ETPs
Exchange-traded products (ETPs) come in two forms, funds and notes.
ETFs
An ETF (exchange-traded fund) can be defined as a fund issued by an investment company. More specifically, an ETF is a single security, listed on an exchange that represents an ownership interest in a portfolio of securities held in trust by a custodian.
There are three types of funds. The chart below explains the differences among them.
Open End
- An open-end fund can issue or redeem shares at any time.
- An investor can purchase shares in open-end funds directly from the issuer, not from other investors in the secondary market. An investor can also redeem these shares in a similar manner.
- All shares issued or redeemed are done so at the NAV (net asset value).
- Actively or passively managed.
- Fees include operating expenses, sales “loads”, 13b-1 fees, redemption fees, maintenance fees, and others.
- Regulated under the 1940 Act.
Closed End
- A closed-end fund issues a finite number of shares that will then trade on an exchange.
- The fund is typically closed to new capital after launch.
- An investor can purchase shares of the fund in the open market.
- The market price of the shares can vary significantly from NAV -this is known as a discount or premium to NAV.
- Costs to the investor include broker commissions and operating expenses.
- Regulated under the 1940 Act.
ETFs
- Exchange-traded funds have characteristics of both open-end and closed-end funds.
- They can create or redeem shares, like an open-end fund, but in large blocks known as “Creation Units”.
- They are exchange-listed and tradable during the day like a closed-end fund.
- Through arbitrage, they trade very close to their NAV (more later).
- Passively managed; track underlying index.
- Modified capitalization-weighted index designed to track the performance of a market consisting of the 1 00 largest and most actively traded non-financial domestic and international securities listed on the NASDAQ stock market, based on market capitalization.
- Ticker: NDX. Market Capitalization: $4 trillion. The NDX was extremely popular during the tech bubble and the success of the ETF QQQ helped drive the current market in ETFs.
ETF Basics
As we mentioned previously, an ETF is a security, listed on an exchange that represents an ownership interest in a portfolio of securities held in trust by a custodian.
The custodian is responsible for maintaining the portfolio of securities, publishing the NAV, performing creations/redemptions, and all other mechanical aspects of running the fund. The custodian charges a management fee as a percentage of assets under management of the fund to perform these functions.
Management fees are typically lower for ETFs as compared to open-end or closed-end funds. Though, for specialized, international or exotic ETFs, the fees may be higher. There are no sales or distribution fees, as in a mutual fund.
The fund sponsor is responsible for the marketing and distribution of the fund. Examples of sponsors include: Black Rock, State Street Global Advisors, Vanguard, and Powershares.
Asset Growth of US-Traded ETFs
ETPs
ETF Mechanics
Dividends
There are four ways ETFs can handle dividends paid by the underlying stocks:
- The dividends are accrued by the fund, held as cash, and distributed on a quarterly basis.
Example: SPY - The dividends are immediately distributed to the ETF shareholders.
Example: HOLDRs - The dividends are accrued by the fund and reinvested in the fund until the quarterly distribution.
Example: IVV - The dividends are accrued via a total return swap and add to the NAV rather than being distributed.
Creation/Redemption Process
Each fund has a group of participating broker-dealers who are authorized participants (APs) in the fund. Only these broker-dealers have the ability to create or redeem shares.
An ETF creation occurs when a dealer exchanges a basket of stock for shares of the fund.
An ETF redemption occurs when a dealer exchanges shares of the fund for a basket of stock.
Creation transactions typically take place in large lot sizes know as creation units and represent 50,000 shares. When a custodian executes the transaction, a nominal fee is charged. The fee is the same regardless of the number of units transacted.
Net Asset Value {NAV)
The NAV is critical to understanding how to value an ETF. The fund publishes a NAV on a closing basis, and usually an intraday basis.
The creation/redemption feature of ETFs forces the fund to trade near NAV due to arbitrage principles.
For example:
Assume 10 successive customers each buy 250,000 SPY, Broker/Market Maker sells and executes basket hedges.
This position, if held, is large and capital intensive.
We also borrow a large number of SPY shares.
By creating 2.5mm shares to flatten the position, the size of SPY fund grows by 2.5mm shares.
AUM therefore grows by $250,000,000.
The process works in reverse when customers sell shares of SPY and Broker/Market Maker redeems.
Market Making
The bid-offer spread in ETFs is dependent entirely on liquidity, volatility, and portfolio correlation. Liquidity is the most important consideration in hedging. Hedging can be executed by trading the ETF itself, the underlying basket, a stock index futures contract, or by trading a different but correlated ETF or basket.
Borrowing
ETFs can be hard to borrow. Some funds launch with a small number of shares outstanding and represent a slice of the market that is better suited for hedging than long exposure. The act of selling shares short results in fewer shares being available to borrow (through the redemption process).
Benefits of Trading ETFs
Investors use ETFs to express macro views, play market momentum, access multiple classes via an equity product, and hedge their portfolio.”
The index never traded above $201, but the opening price of the Index basket equals the sum of the opening price in the stocks.
XYZ op= A op+ B op+ C op+ D op= $51 + $51 + $51 + $51 = $204
The opening price of $204 is $3 higher than the highest traded price in the index. A basket of stock executed market on open would capture this price. A basket executed live would not.
This difference of the settlement price from trading price can be offset provided the holder of the option {long or short) executes a stock basket of equivalent index exposure on the opening print. For example, imagine we are Ions the XYZ 210 put. Based on the previous close of $200, the settlement value of the put would be $10. Because settlement was $204, the puts expire worth $6. If we then replace the risk exposure by selling the basket after the open in the market, we expect to sell it at $200 for a net loss of $4. If, on the other hand, we sell the basket on the opening print at $204, then when the stocks trade back to $200 we earn back the $4 making us indifferent to the actual settlement price.
ETPs
ETNs
ETNs (exchange-traded notes) are a type of senior, unsecured, unsubordinated debt Instrument. They are designed to provide investors a way to access the returns of market benchmarks or strategies. ETNs are not equities or index funds, but they do share several characteristics. For example, like equities, they trade on an exchange. Like an index fund, they are linked to the return of a benchmark index.
ETNs do not own a portfolio of stocks, rather the value of the note tracks the benchmark. The holder of an ETN holds a debt security where the ability of the ETN to pay back principal and performance is linked to the issuer.
Because an ETN maintains its exposure to its benchmark via swap, it can access more complicated or expensive portfolios of underlyings. For exam pie, algorithmic baskets are very difficult to maintain under a physical creation process. But, because ETNs use cash creation instead, this is greatly simplified. ETNs can also provide exposure to capital markets where direct ownership of the underlying is controlled or regulated.
There are several ETN issuers.