Indexology^® Blog

In the 20 years ending in 2020, 94% of all large-cap U.S. managers lagged the S&P 500^®. Mid- and small-cap results were almost equally disappointing. A notable consequence of these shortfalls in active performance has been the rise in passive investing, one of the most significant trends in modern financial history.

Our recent Annual Survey of Indexed Assets shows a surge in assets tracking the S&P 500 to $5.4 trillion as of December 2020. Exhibit 1 illustrates that this growth outpaced the growth due to market gains, indicating a substantial increase in flows.

To provide perspective on the size of the passive market, we can analyze indexed assets historically as a percentage of float-adjusted market capitalization. Exhibit 2 shows that this percentage has grown dramatically, from 10% in 1996 to 17% in 2020. While indexing has grown substantially, the potential for future growth is promising. 

Among the many benefits of indexing is its low cost relative to active management. As indexing has grown, investors have benefited substantially by saving on fees and avoiding underperformance. We can estimate the fee savings each year by taking the difference in expense ratios between active and index equity mutual funds, and multiplying this difference by the total value of indexed assets for the S&P 500, S&P 400^TM, and S&P 600^TM. When we aggregate the results, we observe that the cumulative savings in management fees over the past 25 years is $357 billion (see Exhibit 3).

35 Years of Hedging Indices

Below are three Cboe S&P benchmark indices that theoretically “buy “SPX put options as part of their index methodology and have 35 years of back-tested performance history going back to June 30, 1986.  As shown below, the three options indices were introduced in either 2008 or 2015, and the data histories before the introductions are back-tested.

• Cboe S&P 500 5% Put Protection Index (PPUT^SM) tracks the performance of a hypothetical strategy that holds a long position indexed to the S&P 500 Index and buys a monthly 5% OTM SPX put option as a hedge. The PPUT Index was introduced in 2015.
• Cboe S&P 500 95-110 Collar Index (CLL^SM) tracks the performance of a strategy that purchases stocks in the S&P 500 Index, and each month sells SPX call options at 110% of the index value, and each quarter purchases SPX put options at 95% of the index value. The CLL Index was introduced in 2008.
• Cboe S&P 500 Zero-Cost Put Spread Collar Index (CLLZ^SM) tracks the performance of a hypothetical option trading strategy that 1) holds a long position indexed to the S&P 500 Index; 2) on a monthly basis buys a 2.5% – 5% SPX put option spread; and 3) sells a monthly OTM SPX call option to cover the cost of the put spread. The CLLZ Index was introduced in 2015.

Histogram and Less Tail Risk

The histogram chart shows that the methodology element of theoretically “buying” of puts by the PPUT Index helped lessen the left tail risk when looking at back-tested data over 35 years. The S&P 500 Index had 35 monthly declines of down 6% or more, while the PPUT Index had 18 such declines. There is a hypothetical cost imputed to the Index for the for the paying of premiums for the put options, and the PPUT Index also had fewer monthly gains of more than 4%.

Lower Betas and Standard Deviations for the Indices

In their analysis of potential asset classes for diversification purposes, asset managers may look to see investments with relatively low betas.  The table below shows that all three Cboe S&P indices had betas of less than 0.75 over the 35-year period. The three Cboe S&P indices had higher annualized returns than the MSCI EAFE Index, but lower than the S&P 500 Index.

To Learn More

• Please register for Webinar on 35 Years of Options Index Performance on July 28, 2021, featuring four speakers, including Gaurav Sinha, Managing Director, Head of Americas, Global Research & Design, at S&P Dow Jones Indices (S&P DJI)

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Disclaimer

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606 or at www.theocc.com. The CLL^SM, CLLZ^SM, and PPUT^SM indexes (the “Indexes”) are designed to represent proposed hypothetical options strategies. The actual performance of investment vehicles such as mutual funds or managed accounts can have significant differences from the performance of the Indexes. Investors attempting to replicate the Indexes should discuss with their advisors possible timing and liquidity issues. Like many passive benchmarks, the Indexes do not take into account significant factors such as transaction costs and taxes. The three Cboe S&P indexes in this blog were announced in either 2008 or 2015 as set forth above.  Information presented prior to the announcement dates is back-tested. Back-tested performance is not actual performance, but is hypothetical. A limitation of back-tested information is that it reflects the application of the Index methodology in hindsight. No theoretical approach can completely account for the impact of decisions that might have been made during the actual operation of an index. Cboe Global Indices, LLC calculates and disseminates the Indexes pursuant to an agreement with S&P Dow Jones Indices LLC (“S&P DJI”). CLL^SM, CLLZ^SM, and PPUT^SM are service marks of Cboe Exchange, Inc. or its affiliates. S&P®, S&P 500® and SPX® are registered trademarks of Standard & Poor’s Financial Services, LLC (“S&P”) and have been licensed for use S&P DJI and sublicensed by Cboe Exchange, Inc.  The S&P 500 and S&P GSCI are products of S&P DJI.  Any products (including options) that have the S&P Index or Indexes as their underlying interest are not sponsored, endorsed, sold or promoted by S&P DJI or S&P and neither S&P DJI nor S&P makes any representations or recommendations concerning the advisability of investing in products that have S&P indexes as their underlying interests.

In our past blog, Introducing the S&P Dividend Growers Indices, we highlighted the key objectives and investment rationale behind the S&P U.S. Dividend Growers Index and S&P Global Ex-U.S. Dividend Growers Index. We showed that companies that have consistently increased dividends over consecutive years displayed greater financial strength through being generally more profitable with less stock price volatility. In addition, we provided evidence that the highest dividend yielders were typically more likely to have earned this accolade through poor recent stock price performance. These same companies subsequently showed a higher tendency to make unfavorable future dividend policy changes.

Simple Selection

The S&P Dividend Growers Indices were designed to take advantage of these findings in a transparent and effective two-step selection procedure.

1. Identify the eligible pool of companies that have increased dividends every year

• For at least 10 years in the U.S. and 7 years in the Global ex-U.S. universe

2. Remove high-yielding companies that rank in the top 25% of eligible companies

Deliberate Detail

Investability is key. And designing an index with this in mind involves two interlinked considerations:

1. Maximizing the potential capacity of any investment strategy that could seek to replicate it; and
2. Minimizing the trading costs that may be incurred to ensure the index can be efficiently replicated.

The former involves broadening the selection criteria to expand the total market capitalization selected. The latter involves reducing the total turnover of the index, while ensuring there is sufficient liquidity.

All these elements were carefully considered within the S&P Dividend Growers Indices to improve investability in the following ways.

• Expansive Selection – S&P DJI’s broadest U.S. and Global Ex-U.S. BMI universes were chosen to ensure the widest eligible selection.
• Weighted by Float-Adjusted Market Capitalization (FMC) – FMC-weighted indices have multiple benefits for investability.
  • Liquidity is enhanced since index weights are proportionate to the market value of the free-float shares that are available to investors (excludes closely held shares).
  • Turnover is limited since index weights do not need to be periodically adjusted (only index reconstitutions impact turnover).
  • Capacity is improved by preventing high ownership in any individual company.
• Three-Day Rebalance Window – Reconstitutions only occur annually, and index changes are spread across three consecutive trading days. For those wishing to replicate the index, this reduces market trading on any given rebalance day and therefore lowers market impact costs.
• Buffer Rule on Dividend Yield Screen – To reduce unnecessary turnover, stocks that already exist in the index are only excluded if their yield ranks within the highest 15% (whereas new stocks entering the index are ineligible if they rank in the highest 25%).
• Liquidity Screening – Stocks must satisfy minimum median daily-value-traded thresholds of USD 1 million and USD 0.5 million for the U.S. and Global ex-U.S. indices, respectively. Liquidity buffer rules are also implemented.

Repeatedly Reviewed

Since reconstitutions occur annually, a continual dividend review process is important. Constituents are monitored monthly to allow the index to react to unfavorable dividend policy changes that may signal financial distress. A company may be removed through the monthly dividend review process if it omits a scheduled dividend payment or announces a stop or a reduction to dividend payments.

Evaluating Effectiveness

While rationale and approach are critical, results are equally important. So, how have these indices performed? In the next blog in the series, we will evaluate the historical effectiveness and characteristics of the strategy.

Four Option Benchmark Indices

In order to assess how hypothetical options strategies performed in various market regimes over the past 35 years, investors use some or all of these four key benchmark indices that sell S&P 500 options as part of the their index methodology and that have histories going back to June 30, 1986. As shown in the table below, the four options indices were announced in either 2002, 2007 or 2015, and the data histories before the announcements are backtested.

Use of S&P 500 Cash-Settled Options

All four of the above benchmark indices incorporate a methodology pursuant to which the indices “sell” S&P 500 options. In the past quarter (1) the average daily volume in notional terms for the large-sized S&P 500 (SPX® and SPXW) cash-settled index options topped $500 billion, and (2) the average daily open interest was 14.4 million contacts for the S&P 500 (SPX and SPXW) options, and 400,511 for the Mini-SPX (XSP^SM) cash-settled index options.

Risk-Adjusted Returns

When looking at back-tested data for the past 35 years, three of the “option-writing” indices – PUT, BXMD, and CMBO – reflected higher risk-adjusted returns (as measured by the Sortino Ratio) than the other six indices in the table below. For discussions of option-writing indices, and the Sortino Ratio and other measures of risk-adjusted returns, please see the white papers by Wilshire, Callan, and Ibbotson Associates. The papers also have discussions of the volatility risk premium that may facilitate long-term risk-adjusted returns by index option-writing strategies.

Table with Metrics for “Option-Writing” Indices

Key highlights in the table below with the back-tested 35-year performance of four Cboe option-writing indices and four other indices:

• Lower Standard Deviations: All 4 Cboe S&P indices had lower standard deviations than the stock and commodity indices.
• Less Severe Maximum Drawdowns: All 4 Cboe S&P indices had less severe maximum drawdowns than the stock and commodity indices.
• Risk–Adjusted Returns: Three of the Cboe S&P indices (BXMD, PUT, and CMBO) had higher risk-adjusted returns (as measured by the Sharpe and Sortino Ratios) than the other 5 indices.
• Annualized Returns: The annualized returns of the 4 Cboe S&P indices were higher than those of the MSCI EAFE Index (USD), the 30-Year US Treasury Bond Index (FTSE), and S&P GSCI (for commodities), but less than that of the S&P 500 Index.
• Lower Betas: The four Cboe S&P indices had betas to the S&P 500 that ranged from 0.57 to 0.82, indicating that they may be examined for potential to help diversify certain portfolios.

To Learn More

• Please register for Webinar on 35 Years of Options Index Performance on July 28, 2021, featuring four speakers, including Gaurav Sinha, Managing Director, Head of Americas, Global Research & Design, at S&P Dow Jones Indices (S&P DJI)

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Disclaimer

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606 or at www.theocc.com. The BXM^SM, BXMD^SM, PUT^SM, CMBO^SM, and PPUT^SM indexes (the “Indexes”) are designed to represent proposed hypothetical options strategies. The actual performance of investment vehicles such as mutual funds or managed accounts can have significant differences from the performance of the Indexes. Investors attempting to replicate the Indexes should discuss with their advisors possible timing and liquidity issues. Like many passive benchmarks, the Indexes do not take into account significant factors such as transaction costs and taxes. The four Cboe S&P indexes in this blog were announced in either 2002, 2007, or 2015.  information presented prior to the announcement dates is back-tested. Back-tested performance is not actual performance, but is hypothetical. A limitation of back-tested information is that it reflects the application of the Index methodology in hindsight. No theoretical approach can completely account for the impact of decisions that might have been made during the actual operation of an index. Cboe Global Indices, LLC calculates and disseminates the Indexes pursuant to an agreement with S&P Dow Jones Indices LLC (“S&P DJI”). BXM^SM, PUT^SM, CMBO^SM and BXMD^SM are service marks of Cboe Exchange, Inc. or its affiliates. S&P®, S&P 500® and SPX® are registered trademarks of Standard & Poor’s Financial Services, LLC (“S&P”) and have been licensed for use S&P DJI and sublicensed by Cboe Exchange, Inc.  The S&P 500 and S&P GSCI are products of S&P DJI.  Any products (including options) that have the S&P Index or Indexes as their underlying interest are not sponsored, endorsed, sold or promoted by S&P DJI or S&P and neither S&P DJI nor S&P makes any representations or recommendations concerning the advisability of investing in products that have S&P indexes as their underlying interests.

The S&P 500^® and the Dow Jones Industrial Average^® (DJIA) are two of the best known and most used indices in the world. They are both designed to represent U.S. large-cap companies. As we detailed in a recent paper, the S&P 500 and DJIA have similar long-term risk/return profiles. As of April 30, 2021, the DJIA posted a slightly higher 30-year annualized return of 11.16%, relative to 10.60% for the S&P 500. In addition, the three-year rolling correlation between the index returns was high, averaging 0.95 from April 1993 to April 2021.

However, when we look under the hood, we can see that these iconic indices followed different paths to achieve similar results. The S&P 500 currently includes 505 constituent companies, whereas the DJIA only has 30. They also employ different weighting schemes. The S&P 500 is float market capitalization weighted. This means that the weight of each stock depends on the total size of the company, adjusted for shares that do not trade publicly. In contrast, the DJIA is price weighted, so the stock weights are determined simply by their price.

Here we will highlight three key takeaways from the paper.

The Two Indices Have Experienced Cycles of Relative Performance

In Exhibit 1, we have charted the three-year annualized relative returns between the S&P 500 and the DJIA. During periods when the blue line is above zero, the S&P 500 had outperformed the DJIA over the preceding three years. During the period of the tech bubble burst from June 2000 to June 2003, the S&P 500 significantly underperformed the DJIA.  Part of this underperformance was due to the S&P 500 having a higher weight in the Information Technology sector.

The Top 10 Holdings of the Two Indices Are Quite Different

An analyst who first reviewed the top 10 companies in the S&P 500 and DJIA would not guess that the indices have performed similarly over the long term. As shown in Exhibit 2, as of April 30, 2021, there were only two names in common in each list—Microsoft and Visa. In the paper, we walk through the details of how the weight of Microsoft is calculated for each index.

The Indices Have Provided Different Sector Exposures, Which Can Result in Meaningful Return Discrepancies in the Medium Term

Over the three-year period ending April 30, 2021, the S&P 500 outperformed the DJIA by 4.11% annualized. Exhibit 3 shows the results of a three-year Brinson performance attribution to explain the outperformance. In total, Industrials accounted for 2.00% / 4.11% = 49% of the difference. On average over the past three years, the S&P 500 was underweight Industrials by 10.01% during a time when Industrials underperformed the broad market. We can further decompose the Industrials’ 2.00% return contribution into an allocation effect of 1.14% and selection effect of 0.86%.

When first reviewing the S&P 500 and DJIA, market participants may note their similar long-term risk/return profile and high correlation. However, when we look closer, we can analyze a range of important differences including the number of constituents, top 10 holdings, weighting scheme, and sector exposures. Once investors understand these differences, they can make more informed decisions about using these iconic indices as benchmarks or the basis for passive investment.