Narrow-Based and Sector Indexes Step Up to the Plate
Zwick, Steve, Collins, Daniel P., Modern Trader
Looking to join the tech stock jamboree but leery of picking exactly which corporation will implode next? ft futures on narrow-based and sector indexes: They're legal, workable and coming to an exchange near you.
he last two years have been lucrative ones for S&P 500 traders with a feel for the short side of the T market, but the shifting tides of wealth have been even better for those who were short the tech sector and long consumer goods. To find such a person, however, you would have to look to the options exchanges or OTC world, where puts and swaps based on recognized sector indexes trade alongside those on country indexes like Germany's Dax and France's Cac 40.
What you would find, especially in the swaps arena, is that volume on sector index derivatives rivals that of volume on country indexes - which makes perfect sense in a modern economy where the performance of American banking shares more closely resembles that of their Japanese counterparts in the same sector than of fellow American companies in, say, the automotive sector.
The liquidity for OTC sector swaps comes from both retail and institutional sources, with increasingly more retail investors flocking to sector-oriented mutual funds and exchange-traded funds (ETFs). And increasingly more fund managers adopting a "core and satellites" approach to money management, which entails building a central portfolio benchmarked to a branded index (the "core") and then bulking up on certain subsectors of that index while cutting down on others (the "satellites").
Now both the Chicago Mercantile Exchange (CME) and OneChicago plan to launch futures on sector indexes in the coming months, while Germany's Eurex and Spain's Meff already offer pan-European sector indexes approved for U.S. traders. In fact, Eurex boss Rudi Fersha long has contended that sector futures - and not singlestock futures - will be the next fair-haired product. Sectorial splendor Sector indexes are subsets of broader trademark indexes and reflect the price movement of a definable segment of that index. Although global sectors exist, the more tradable ones are limited to one currency zone. Standard and Poor's, for example, has split the S&P 500 index into nine distinct U.S. market sectors, which have a three-year track record trading as ETFs (see "ETF sectors provides blueprint," page 68).
Index providers differentiate themselves from their competitors in a variety of ways. The S&P 500, for example, has market breadth, while the Dow Jones 30 has blue chip status. At the sector level, they differentiate among themselves in the way they classify components. From a trading perspective, classification standards help determine which indexes can be spread against which others. Both S&P and MSCI are touting the Global Index Classification System (GICS, pronounced "Gicks") as a worldwide standard, but Deutsche Boerse recently announced it was realigning its Dax index to match the classification system followed by the Dow Jones Stoxx sector indexes.
"The composition of the sector basket is one of the most important factors for success," says Bill Russell, director and head of European futures at Citigroup in London. "Whether this composition is successfully traded as an ETF or as a sector futures also depends on exchange marketing, public appetite and the regulatory environment."
The CME's contracts will be based on existing U.S. S&P sectors and range in size from 13 to 70 underlying securities, while OneChicago is constructing narrow-based sectors with only four to six underlying securities each. The components were chosen based on volume traded, both outright and in options, and on their correlation to each other. They will be physically settled and equally price weighted (see "When they say narrow..." above).
Equal weighting means that each underlying stock in the index will start out with equal price representation. If IBM is trading at $70 and Sun is trading at $7, then 1,000 shares of Sun will be represented in the index compared to 100 shares of IBM. …