Demonstrating Arbitrage Using Diamonds and the Dow Jones Industrials Index
Neumann, John J., Review of Business
There are now no fewer than 450 exchange-traded fund portfolios (ETF, HOLDR, or iSHARES) at www.amex.com and listed on the NYSE, a menu of choices which facilitates investor pursuit of a variety of investment objectives. If an investor seeks to allocate a portion of a portfolio to broad equity or bond market indices, to domestic or global markets, in specific sectors or commodities, to follow growth or value-style strategies, or to one or more of the large-cap, small-cap, or mid-cap size segments of the market, there is likely an exchange-traded security available to meet that need.
Both the number of ETF offerings and size of the individual ETF issues have grown over the last decade. Exhibit 1 shows the outstanding shares of a sample of twelve ETF securities over 1998 to 2005, selected to include the most well-known ETFs but also to provide a snapshot of different sponsors or trustees (State Street Global Advisors for SPDRs, Barclays Global Investors for iSHARES, and Vanguard for VIPERs). At year-end 2005, Diamonds (DIA), which tracks the Dow Jones Industrial Average and is the subject of the body of this paper, had seven times as many shares outstanding as compared to 1999. The S & P 500 index-tracking ETF, SPiDeRs, had 17 times more shares than it did in 1998. QQQQ (split-adjusted) shares have grown from 121,400,000 to 501,950,000 since they were introduced in 1999. The iSHARES Russell 2000 security had 117,350,000 shares outstanding at the end of 2005, a rise from 4,500,000 when it was debuted in 2000. Other ETFs in Exhibit 1 reveal similar increases.
Exhibit 2 depicts aggregated average daily trading volume by year for this sample of twelve ETFs, and affirms the growth in popularity of these investment vehicles. Average daily volume in SPY rose by an annual average of 35.5% between 1998 and 2005. Diamonds volume increased by 40.8% on average per year over that time period, while trading volume in the QQQQ climbed by 37% on an average annual basis. Daily volume in the Energy SPDR increased by an average of 109.2% per year from 1999 to 2005, and by 72% annually in the streetTRACKS Wilshire REIT from 2001 to 2005. This is not so surprising given the performance of energy sector and REIT stocks over the recent past, and these statistics reveal that investors turned in no small way to the ETFs to participate in those market cycles.
Introduced in 1998, Diamonds is the ETF designed to track the portfolio of stocks in the Dow Jones Industrial Average (DJIA) index of 30 large, industry representative, long track-record companies. The individual stocks in the DJIA index are all subject to their own buying and selling pressures throughout the day, as company or macroeconomic news is digested by the markets and capitalized into the prices of these securities. Diamonds, as a stand-alone security, must also be subject to buying and selling pressures. One can envision a piece of news being released which motivates investors to transact in the ETF, but not the individual companies, perhaps because the news is so fundamental--a systematic news event, in modern portfolio theory terms, that is expected to have an on-average effect on "the market." The most efficient way for the average investor to trade on this news, then, is to buy or sell "the market," as captured by the index upon which the ETF is based. Conversely, news might be released about individual companies in the index that attracts investor attention to these individual stocks, more so than to the portfolio as a whole, for example during earnings reporting periods. With these potentially disparate forces at work, it is natural for students to wonder what prevents a share of an independent ETF security from becoming too disconnected from the underlying portfolio of stocks to which it is tied so that it consistently fulfills its objective of tracking the underlying index. This article is an educational tool which answers that question within the context of a pedagogical treatment of arbitrage. …