Suddenly Sectors

June 28, 2005

The options exchanges are launching proprietary sector indexes left and right; be ready for a battle for market share.

In the past few months, three of America's six equity options exchanges have unveiled new proprietary sector indexes.  In May, the Philadelphia Exchange kicked things off with the launch of a new biotech index.  The International Securities Exchange followed suit by unveiling six new indexes on June 6.  And on June 23, the Chicago Board Options Exchange (CBOE) topped them all by unveiling twelve new sector indexes, called "PowerPacks," covering everything from oil to biotechnology to gold.

Seen individually, the announcements are interesting enough: The launches include a number of rather innovative indexes, including PHLX's biotech index, which captures the most intriguing slice of the biotech universe, and ISE's "Homeland Security" index, which offers an interesting way to hedge against future terrorist attacks.

But taken together, the announcements look even more interesting - and even more important. Taken together, they point towards two important trends in the capital markets.

Sector Investing Is Booming

The first trend worth noting is the tremendous boom in sector-based investing.  The Select Sector SPDRs - a family of nine sector-based exchange-traded funds (ETFs) - experienced record growth in May, with assets under management rising $1.75 billion (or 17 percent) for the month.   That topped the previous monthly record of $1.3 billion, set in February, and continued a trend that has been building all year: While industry-wide ETF assets were up eight percent for the year through May, the amount of money tied to the Sector SPDRs was up more than 26 percent.

There are many factors contributing to the rising interest in sector-based investing, but one of the most important was highlighted recently by Dan Dolan, chief architect of the Select SPDRs, in an interview with Morningstar.com.

"Every time a blue chip stock gets stung by bad headlines, more and more single-stock investors come to favor the diversification a Sector SPDR can offer," said Dolan.  "If you are looking to capitalize on a specific investment theme you no longer need to expose your portfolio to single stock risk."

In the post-Enron era, ETFs and sector-based options are offering investors the chance to diversify away from company-specific risk, while still allowing them to play emerging themes in the market.  And increasingly, investors are seizing this opportunity.

Exchanges Looking To Capitalize - And Replace Exclusive Listing Agreements

Rising interest in sector-based investing may explain some of the recent activity from the the options exchanges, but it can't explain all of it.   After all, if the exchanges were really just looking to offer exposure to sector themes, they could trade options on existing sector indexes. 

Why, then, are they taking the trouble to develop their own indexes?  The answer, I think, lies in the comments that Chicago Board Options Exchange (CBOE) Chairman and CEO William Brodsky made on the day the CBOE unveiled its new PowerPacks:

"We are pleased to introduce this new family of sector indexes, developed to meet the evolving needs of our customers… Despite the current challenges to proprietary index options, CBOE remains strongly committed to responding to changing investment needs and opportunities through index product innovation."

The emphasis is mine.

As chronicled extensively in this space, the options industry has undergone a major transformation vis-à-vis indexing over the past few years.  In the past, index options traded exclusively on a single exchange: If you wanted to trade options of the Russell 2000 Index, for instance, you went to the CBOE - or you didn't trade them at all.  Exchanges like the CBOE expended considerable energy - and developed considerable expertise - in supporting and building a client base for these proprietary index options.

With the growth of electronic trading, however, exclusive contracts have been replaced by multiple listings.  Today, Russell 2000 contracts are available at all six leading U.S. equity options exchanges.  In general, the change has been good: Options volume is up significantly, thanks in part to the tighter spreads created by these multiple listing arrangements.

The transition has been challenging, however, for the original holders of those exclusive listing agreements, who have seen their 100 percent market shares eaten into by eager competitors.

By developing proprietary sector indexes, these exchanges can use their expertise in cultivating the index options market for their own benefit - expertise that would otherwise be lost as the transition to multiple listings. 

As this trend continues, expect to see a major battle over market share, as the different exchanges duke it out to attract volume to their index.  The stakes will be high, too, because volume begets volume in the options industry: If one index attracts the bulk of early trading volume, it will be hard for other indexes to compete with the lower spreads and high liquidity of the early leader.  Whoever develops the market first may own the market for the long-term.

PowerPacks Cover Twelve Sectors

The new CBOE indexes - dubbed "PowerPacks - launched on June 23, and cover the following sectors: Banks, biotechnology, gold, Internet, iron & steel, oil, oil services, pharmaceuticals, retail, semiconductor, technology, and telecom.  Options and futures based on the indexes will launch on July 8.  Like all index options, options on the PowerPacks may offer tax advantages for short-term traders.

The new indexes will be modified cap-weighted indexes, with component weights capped at 10 percent to prevent one component from dominating any of the indexes.  Each index is made up of 25 companies.

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