Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance

CHAPTER 1

Owning the Index

Is indexing a strategy or a philosophy? In this chapter we make the case that it’s a little of each, and tell the story of how fifty years ago a combination of advances in computing technology and research in risk management set the groundwork for a revolution in both the science of and attitudes toward investing.

While the financial industry was initially slow to embrace the practice of indexing, the brightest minds in financial academia have been researching the subject for decades, and here we present a collection of some of the most interesting and practical findings, including the results of one ground-breaking paper published by Eugene Fama and Kenneth French in 1964, and another by the same team in 2007.

One of the most researched topics in the long-term behavior of indexes is whether there are patterns or trends in the pricing of indexes that can be identified and possibly exploited. Many investors have beliefs and assumptions that are based upon little hard evidence, and in this chapter we present the most up-to-date research in this area.

THE STORY OF INDEXING

The Standard & Poor’s 500 Index (S&P 500) was created in 1957, but the first index fund didn’t appear until 1973, and index funds didn’t become mainstream until the mid-1980s. Why the delay?

We might not yet have index funds today if not for advances in computer technology. Robert Noyce, of Fairchild Semiconductor, invented the first practical integrated circuit in 1959, making possible ...