3rd July 2017


The Dow Jones is one of the oldest share market indices and probably the best known. The Dow Jones Industrial Average (to give it its full name) was created in 1896 by Charles Dow and Edward Jones in order to give an aggregate picture of trading on the New York Stock Exchange. The Dow is currently owned and managed by a subsidiary of S&P Global, which also owns and manages the Standard & Poor’s indices. It is based on the share prices of its thirty constituent companies, which are selected by an arcane process.

The Dow started out in 1896 at a value of 40 and has now passed 21,000. This growth tends to show how much the value of the US share market has increased in the last century. But the Dow is not in fact much use as an index. The purpose of a share market index is to record changes in market value over time. Therefore, an index needs to represent the underlying market accurately, to respond consistently to changes in market values, and to be derived by clear rules.

The S&P500 index (made up of five hundred US companies) is much more widely followed by professional investors than the Dow. The thirty companies included in the Dow are large by market capitalization, but many large-cap companies are excluded from the Dow, such as Google, Facebook and Amazon. Hence the Dow is not representative of large US companies, let alone of the broader US share market.

The Dow performs badly as an index because it is calculated by adding up the share prices of its constituent companies, not by adding up their market capitalizations. Thus Exxon’s share price of USD$82 means that it is a smaller contributor to the Dow than Caterpillar, which has a share price of USD$105. But Exxon has a market capitalization of USD$348 billion, more than five times larger than Caterpillar, which is worth only USD$62 billion.

The other indices operated by S&P Global, including its Australian indices, are much better designed. They are calculated by adding up the market capitalization of companies, subject to constraints on tradability (also referred to as “liquidity”). Liquidity in trading is important because index funds and ETFs need to be able to replicate any given index, so a company which is not frequently traded should not be included in a market index.

Three index providers – S&P Global, FTSE Russell, and MSCI – dominate the supply of indices around the world. For example, these three provide the indices for 73% of US equity mutual funds worth more than USD$9 trillion in total. S&P Global alone calculates more than 1 million indices per day. Indices for the bond market are dominated by Barclays. Unlike investors, index providers have no interest in whether indices go up or down.

Indices are often broken down by industry sectors. Since 1999, the major index providers have used the Global Industry Classification Standard (GICS), which is a four-tier taxonomic system comprising 11 sectors, 24 industry groups, 68 industries, and 157 sub-industries.

It is also possible to subdivide indices in ways other than size (market capitalization), e.g. including only companies which are profitable or companies which pay dividends. Indices can also be constructed which aggregate companies on criteria other than size, such as sales or profits, but these are not good indicators of changing market value.

It is important to note the value of an index is correlated with the aggregate market capitalization of the companies in that index, but is by no means identical to it. The two would be perfectly correlated if there were no changes in the composition of the index over time, but indices do in fact change frequently as companies are included or excluded. The entry or exit of a company triggers a re-set of an index: at the close of trading, the index is calculated first before the change, then again after the change, and the second calculation is used as the new index number going forward. This adjustment process is known as “chain linking”.


The world’s first ETF began trading in January 1993, with the code SPY, to track the S&P500 index. The concept had been developed by the American Stock Exchange in 1988, then subjected to four years of stress testing by the SEC. Formally, it was a Unit Investment Trust under the 1940 Investment Company Act, and its official name was SPDR, for Standard & Poor’s Depositary Receipts. Today SPY has USD$239 billion in net assets.

The key to the usefulness of the ETF lies in its two-tier mechanics and guaranteed market-making. As the official name suggests, what investors buy and sell is receipts, not shares. The receipts represent claims on underlying shares which are held in a “warehouse”. Receipts are created (redeemed) by authorized agents as the size of the ETF increases (decreases). The trading of the receipts is carried out separately on an exchange by a market-maker who guarantees to provide specified volumes within a fixed buy-sell spread. Thus the investor can buy or sell at any time, without having to wait for a counter-party to turn up, as in the case of shares.

The early ETFs were used to track major share market indices, in much the same way as index funds did. ETFs became increasingly popular because they were tax efficient, their management expenses were usually lower than index funds, and investors found that trading ETFs was easier than applying for and redeeming units in index funds. They were also transparent and anonymous, all ETFs used the same standardized legal structure, and the ETF manager had a fiduciary duty to investors.

There are now over 2,000 ETFs listed in the US, with a value in excess of USD$3 trillion. (By comparison, US mutual funds exceed USD$16 trillion.) The major ETF issuers are Vanguard, BlackRock (iShares), and State Street, who account for 80% of ETFs by value. In Australia at 31 May 2017, there were 206 ETFs listed, with a value of $29 billion.

Although the largest ETFs are still the passive index trackers, the advantages of the ETF as an instrument have encouraged issuers to experiment. ETFs have also been designed to meet the needs of individual institutions. Thus it is possible to find highly specialized index ETFs, such as those which track specific equity sectors in certain countries, or certain types of bonds. There are also geared ETFs, actively managed ETFs, ETFs which track commodities, and even more exotic vehicles.

Arminius makes extensive use of ETFs in the funds which we manage. But there are many tricks and traps to the use of ETFs, which we will explore in a later Geldzug.