Tim Olson
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| Background on index investing: an index is a diversified portfolio of assets with defined weights, and investment vehicles such as futures and ETFs allow efficient, single-trade exposure to broad indexes. |
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Index Generalities
Section: 6.1 | Asset Class: Indexes | Type: Background / Reference
Overview
An index is a diversified portfolio of assets combined according to specified weights. The underlying assets are typically stocks (e.g., DJIA, S&P 500, Russell 3000). Index weights are determined by price (DJIA) or market capitalization (S&P 500, Russell 3000). Investment vehicles such as index futures and index-based ETFs allow a trader to gain broad market exposure through a single trade.
Construction / Mechanics
Index types by weighting scheme:
- Price-weighted: DJIA — each stock's weight proportional to its price; a high-priced stock has disproportionate influence.
- Market-cap-weighted: S&P 500, Russell 3000 — each stock's weight proportional to its market capitalization (shares × price); larger companies dominate.
- Equal-weighted: each constituent receives the same weight; requires frequent rebalancing.
Investment vehicles:
- Index futures: standardized contracts to buy/sell the index at a future date; require no upfront payment of the full notional (margin only); settled in cash.
- Index ETFs: exchange-traded funds that hold (or replicate) the index constituents; trade intraday like stocks; e.g., SPY (S&P 500), IVV (iShares S&P 500).
- Both instruments allow leveraged or hedged exposure to the index.
Key Concepts
- Spot price S(t): current value of the index based on constituent prices.
- Futures price F(t,T): price of the futures contract with delivery at T; theoretically F*(t,T) = [S(t) - D(t,T)] · exp(r(T-t)) where D(t,T) is the present value of dividends and r is the risk-free rate.
- Basis B(t,T): normalized difference between futures price and theoretical fair value; basis trading exploits deviations of B from zero.
- Tracking error: difference between an ETF's NAV return and the index return; minimizing tracking error is a key ETF management objective.
Notes
- Index futures and ETFs are highly liquid, making index strategies generally easier to implement than single-stock strategies.
- Market-cap-weighted indexes concentrate exposure in the largest stocks; this can create significant single-name risk.
- ETF arbitrage (Section 6.4) exploits intraday mispricings between different ETFs tracking the same index.
- Dispersion trading (Section 6.3) exploits the difference between index implied volatility and constituent implied volatilities.