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Introduction to the special issue on equity indexing
Article Type: Guest editorial From: Managerial Finance, Volume 42, Issue 5.
It is noteworthy that this special issue on equity indexing appears in print exactly 120 years since the concept of equity indexing was born, and the first stock market index – Dow Jones Industrial Average – was launched on May 26, 1896. This year also marks the 40th anniversary of the introduction of the world’s first index mutual fund – Vanguard 500 Index Fund (Bogle, 2016). Over this long period, equity indexing has experienced a significant growth that involved the inception of numerous stock indexes, and index-based investment vehicles and securities. This growth does not show any signs of slowing down. New indexes and index-based products are launched almost every day, and their acceptance by the investment community has been nothing short of incredible. As a result, Vanguard 500 Index Fund has become the largest mutual fund, and the exchange-traded fund (ETF) SPDR S&P 500 has been the most widely traded stock in the world.
The academic community has shown significant attention to equity indexes as well, as a growing body of literature examines a variety of issues related to stock market indexes. Equity indexes also facilitate research by routinely serving as benchmark portfolios in academic studies. As a reflection of the significant interest in indexing from both academics and practitioners, a journal focussed entirely on indexing – The Journal of Index Investing – started in 2010 (Bruce, 2010).
Five papers selected for this special issue demonstrate a diversity of research involving equity indexing. The first two papers examine issues related to ETFs. The third paper develops an equity indexing technique to form cointegration tracking portfolios. Finally, the last two papers use equity indexes to analyze comovements and financial integration of markets of different countries. More detailed summaries of each paper are provided below.
The first paper, "Determinants of tracking error in German ETFs – the role of market liquidity" (Osterhoff and Kaserer, 2016), examines the effect of liquidity on tracking error of ETFs by using a sample of eight ETFs that track Germany’s DAX equity indexes. As the goal of a typical ETF is to closely track its target index, a large body of literature studies factors that determine the magnitude of tracking error. This paper contributes to the literature by empirically examining the impact of two factors on ETF’s daily tracking error: liquidity of underlying stocks, which is measured as a weighted index of liquidity of all stocks in the ETF portfolio, and the creation and redemption of ETF shares. The authors find that a decrease in the liquidity of underlying stocks and an increase in the daily change in ETF shares lead to higher tracking error. Consistent with previous studies, the paper reports that ETF management fees, cash holdings, and dividend yield of underlying stocks are associated with higher tracking error as well. In contrast, cash distributions to ETF investors and changes in the composition of the underlying index are associated with lower tracking error. As no single measure can capture all aspects of liquidity of individual stocks, the paper proposes the analysis of other liquidity proxies as an avenue for future research.
The second paper, "Leveraged ETF option strategies" (Trainor and Gregory, 2016), deals with relatively new equity index securities: leveraged ETFs and options on leveraged ETFs. Applying put-call parity, the authors develop a pricing relationship between options on the underlying index and the associated leveraged ETF. Using the derived pricing relationship, the paper examines covered call and protective put strategies. This empirical analysis shows that options on ETFs or on the underlying index can successfully replicate leveraged ETF options. This result has implications for traders, as the options market for the leveraged ETF is still relatively thin in comparison to the market for the index or the unleveraged ETF options.
The third paper, "Cointegration-based trading: evidence on index tracking and market-neutral strategies" (Papantonis, 2016), analyzes cointegration-based trading strategies. To form cointegration tracking portfolios that can mimic the risk-return profile of an index, the paper introduces an equity indexing technique. The paper shows that under certain parameter specifications, a cointegration portfolio can be profitable by capturing mean-reverting spreads in market trends. The author enhances the simple index tracking technique to develop long-short market-neutral strategies. The back-testing of these strategies indicates that some of them also can beat the benchmark and demonstrate only minor correlation with market risk factors. To examine if the observed profitable cointegration-based pair-trading strategies violate market efficiency, the paper uses a test for statistical arbitrage. Although some trading strategies can be highly profitable, the test results show that these strategies do not produce risk-free arbitrage. Thus, market efficiency still holds. As a useful implication for traders, the probability of losses for the examined strategies slowly declines as the investment horizon lengthens.
The fourth paper, "Cyclical comovements of the world equity indexes" (Zhou, 2016), presents a comprehensive analysis of synchronization in stock market cycles by examining the weekly behavior of equity indexes of 82 countries. The paper identifies bear and bull cycles for all 82 stock market indexes over the 1975-2010 period and compares differences between G8, non-G8 industrialized, and developing countries. Specifically, the paper reports lower absolute total and weekly returns in both bull and bear cycles for industrialized countries compared to developing countries. However, stock market indexes of all countries generate higher gains during bull cycles than losses during bear cycles. The average duration of bull cycles is about 1.5-2 times longer than that of bear cycles for all countries as well. The paper also finds that industrialized countries are more synchronized with other countries than developing nations. In addition, trade openness, GDP, population size, capital openness, and EU membership contribute to a country’s stock market synchronization. However, their magnitude varies for different group of countries. For instance, trade openness has much larger impact on stock market synchronization for developing countries than for industrialized nations. The paper concludes with several suggestions for future research.
The fifth paper, "Financial integration and diversification benefits: China and ASEAN4 countries" (Pana and Nguyen, 2016), examines financial integration between China and Association of Southeast Asian Nations (ASEAN)4 countries (Indonesia, Malaysia, Philippines, and Thailand) following the adoption of the strategic partnership plan between China and ASEAN in 2004. Consistent with previous studies, the paper finds that financial integration reaches its peak during the recent financial crisis. The authors extend the literature by documenting a decline of financial integration to the pre-crisis level after the crisis. As for a diversification strategy, the paper shows that investing in industry sectors rather than country indexes provides better diversification benefits. However, diversification benefits decrease as the investment horizon lengthens. Finally, a portfolio combining China and ASEAN4 stock market indexes offers better diversification than a portfolio combining China and European Union stock indexes.
In conclusion, I would like to thank the Editor of Managerial Finance, Professor Don Johnson, for the opportunity to edit this special issue, and for all guidance and support along the way. I am also grateful to the Emerald team of Valerie Robillard and Andrea Watson-Lee for their prompt help and unwavering support. I sincerely thank authors of all submitted papers. Lastly, I owe a special debt to numerous anonymous referees who generously donated their time and expertise to review original submissions and multiple revisions. Without their tireless efforts this special issue would not be possible.
Ernest N. Biktimirov - Goodman School of Business, Brock University, Saint Catharines, Canada
Bogle, J.C. (2016), "The index mutual fund: 40 years of growth, change, and challenge", Financial Analysts Journal, Vol. 72 No. 1, pp. 9-13
Bruce, B.R. (2010), "Editor’s letter", The Journal of Index Investing, Vol. 1 No. 1, p. 2
Nguyen, T.D. and Pana, E. (2016), "Financial integration and diversification benefits: China and ASEAN4 countries", Managerial Finance, Vol. 42 No. 5, pp. 496-514
Osterhoff, F. and Kaserer, C. (2016), "Determinants of tracking error in German ETFs – the role of market liquidity", Managerial Finance, Vol. 42 No. 5, pp. 417-437
Papantonis, I. (2016), "Cointegration-based trading: evidence on index tracking & market-neutral strategies", Managerial Finance, Vol. 42 No. 5, pp. 449-471
Trainor, W. and Gregory, R. (2016), "Leveraged ETF option strategies", Managerial Finance, Vol. 42 No. 5, pp. 438-448
Zhou, H. (2016), "Cyclical comovements of the world equity indexes", Managerial Finance, Vol. 42 No. 5, pp. 472-495