The investment world trusts and relies upon indexes such as the Dow Jones industrial average, S&P 500, Nasdaq 100 and Russell 2000 for gauging market activity. In recent years, this emphasis has become even greater due to the explosion in popularity of tradable index-based products such as ETFs, futures and options. In addition, the market has become increasingly dominated by trading volume from arbitraging index, ETF and other derivative movements versus the underlying equities.
Surprisingly, we have found that on an intraday basis, these widely watched indexes and possibly others are based on less than 30 percent of all shares traded, therefore conveying incomplete trading data. We have confirmed in writing with representatives from Dow Jones Indexes, S&P, Nasdaq and Russell that these indexes are calculated using only primary market data. Nowadays, in a world of microsecond trading, these indexes have become phantoms—they reflect some trades involving their components, but not the majority of them.
This situation raises serious questions about the reliability of index-based trading products. The solution? Simple: Indexes should be calculated based on every trade involving a component that crosses the consolidated tape, which includes trades from nonprimary exchanges such as BATS, Direct Edge and NYSE Arca.