A robust and active trading ecosystem benefits asset owners and investment managers by fostering transparency, market efficiency, and investor confidence. This paper documents, for the first time, the extent and nature of that ecosystem for indices produced by S&P Dow Jones Indices (S&P DJI). The results offer a window into trading around certain market benchmarks, providing a new perspective on the use of indices as the basis for active and passive investment strategies.
- We measure aggregate U.S. dollar total volumes for a range of benchmarks including the S&P 500® and the Dow Jones Industrial Average®.
- We suggest the potential network effects in liquidity that can develop between products tracking related indices.
- We demonstrate that average holding periods can vary widely across index vehicles, illustrating the high level of active usage of some passive investment products.
THE IMPORTANCE OF VOLUMES IN INDEX-LINKED PRODUCTS
The growth in aggregate assets under management in “passive” or indextracking funds and portfolios has been the subject of considerable professional and media commentary. However, while index providers and other organizations regularly produce reports estimating the value of assets tracking (or benchmarked to) indices, comprehensive estimates of secondary market volumes in passive vehicles are harder to find.
This is unfortunate, because volumes can tell us how active the users of passive investment vehicles truly are. Passive funds can, and often do, have active owners who trade in and out of their positions frequently. Volume data can also give us an indication of how well a market is “policed” by arbitrageurs, whose identification and exploitation of mispricings has the potential to operate at the level of entire markets as well as individual constituents.
Volumes are also important to passive investors, even if they have relatively simple objectives. Consider that an investor can buy an ETF linked to the S&P 500, hold it for 20 years, and expect to earn a return comparable to the performance of an index that is reported in the evening news. Such confidence depends on two factors:
- At the time he transacts, whether buying or selling, the investor relies on the work of a small army of arbitrageurs who monitor the relationship between the price of the ETF and the weighted average price of the 500 index components.
- Even when not transacting, the investor can benefit from the continued visibility of the S&P 500. This prominence not only attracts the arbitrageurs who facilitate efficient pricing, but also invites the scrutiny of other market participants and commentators, whose engagement provides transparency and helps ensure that the index continues to accomplish its stated purpose.
Market efficiency is not the gift of a benevolent Providence; it is possible only when there is a trading ecosystem sufficiently large and active to minimize mispricings.