2005: A Look Back

January 02, 2006

A look back at an incredible year in the indexing industry.

Now that the ball has dropped on 2005, it's time for to take a quick look back at the year in indexing.  What a year it was.

Sure, the major U.S. market averages barely budged: The Dow Jones Industrial Average closed within a hair's breadth of where it started the year, and the S&P notched a measly 3 percent gain - not even enough to keep pace with inflation.

But if you were stuck watching the major averages in 2005, you missed the show. Because 2005 was the year investors figured out how to use indexing to beat the major market averages.  And when they weren't doing that, investors were using indexes to track everything besides the old stalwarts. 

A look at some of the top stories of 2005…

Indexes To Beat The Indexes

2005 may well go down as the year of "active indexing." While the idea has been around for a while (Dimensional Fund Advisors has been offering market-beating index funds for years), active indexing took a quantum leap forward in 2005. 

First, PowerShares dramatically expanded its line-up of active index ETFs, moving from 4 to 36 "enhanced index" funds and growing its assets under management from less than $1 billion to over $3 billion.  PowerShares seems determined to offer an "enhanced index" ETF for every market category under the sun - be it size, style, or sector. It's making "enhanced indexing" a real alternative to traditional passive strategies.

PowerShares isn't alone: Even old indexing stalwarts like Dow Jones have gotten into the game.  Dow Jones launched an "enhanced" micro-cap index in June  which promised to use financial screens to better the performance of a straight micro cap index. That bogie quickly became the basis for an ETF from First Trust Advisors.

And perhaps the biggest leap on the active indexing front came towards the end of the year, when Rob Arnott's group, Research Associates, teamed up with FTSE to launch a new suite of "Fundamental Indexes." These indexes use measures like book value and dividend yield to weight stocks, rather than using traditional market capitalization measures; Arnott says that his indexes will beat traditional market cap indexes by 2.5+ percent per year.

Arnott's got a big name in the field, and there was enough buzz around his new indexes for them to win the "most innovative index" award at the 2nd Annual IMN/Indexuniverse.com Superbowl of Indexing.   PowerShares - surprise, surprise - launched an ETF tied to Arnott's U.S. index in December.

Commodities Gusher

Of course, you didn't need any fancy indexing methodology to post solid returns in 2005.  All you had to do was buy commodities - any commodities.  The Dow Jones - AIG Commodity Index closed the year up 18 percent, and many commodity-related funds and ETFs did even better.  The Select Energy SPDR was the fifth best performing ETF of the year through November, rising 37.8 percent, while the broad-based iShares Goldman Sachs Natural Resources fund was up 32.1 percent.

Meanwhile, 2005 also saw major breakthroughs in index investor access to commodities exposure. Traditionally, commodities index funds have been expensive, with 5+ percent loads and expense ratios near 2 percent.  But that started to change this year: The May launch of the EasyETF GSCI in Europe provided European investors low-cost access to the Goldman Sachs Commodity Index (GSCI).

U.S. investors got their own reprieve from the intolerable load charges in December, when Deutsche Bank won approval to launch its own commodity index ETF in the U.S.   Scheduled for launch in 2006, the DB Commodity Index Tracking Fund will have no load, and its expense ratio of 1.75 percent will be offset by 2.5 percent in annual interest income.

Meanwhile, investors looking for direct access to commodities also saw their prospects brighten in 2005, with the launch of an oil-based ETF in London and Mexico.    With two gold ETFs already on the market and a silver ETF in registration, the commodities industry is clearly embracing the ETF revolution.

Go Abroad, Young Passive Investor

If investors weren't making a mint on commodities in 2005, they were cashing in Euros and Yen overseas.  International markets surge in 2005, led by the MSCI Argentina Index, which posted the highest returns of any index (through November), at nearly 59 percent.  Indeed, Latin America in general was hot hot hot: The iShares S&P Latin 40 ETF was the best-performing index fund in 2005, rising nearly 54 percent.  But the good  times spread throughout the world, with the MSCI Japan Index up 40 percent for the year and the DJ STOXX 50 - which measures Europe - rising 21 percent.  Only the U.S., it seems, was not invited to the party.

Investors noticed, too: Net inflows into foreign and global funds hit a record $149 billion in 2005, exceeding flows into domestic funds for the year (Strategic Insight). That's got to be a first.

This rush of money helped the iShares MSCI EAFE fund grow to become the second largest ETF in the world, overtaking the Nasdaq-100 QQQs in November. EAFE now has $22.7 billion in assets.

The BuyWrite Boomlet

Another approach to beating the boring markets this year came from the indexing research department at the Chicago Board Options Exchange (CBOE).  The CBOE launched an index in 2002 called the CBOE BuyWrite Index, which tracks the performance of a basic "buy-write" options strategy used on the S&P 500.  In 2004, a study came out from Ibbotson showing that this nifty index had beaten the S&P 500 over the past decade, and with less risk.  The study attracted enough attention that the index won the first annual IMN/IndexUniverse.com award for Most Innovative Index, in 2004.

Well, investors started paying attention last year. A handful of companies - including Eaton Vance - launched buy-write funds in 2005, and investors poured more than $13 billion into the strategy.     The CBOE was so excited that they launched two new buy-write indexes, tied to the Dow Jones Industrial Average and the NASDAQ-100.

Interest in these strategies helped pushed volume on the options exchanges - and particularly index volume - to record highs.

Changes At The Exchanges

No look back at 2005 could be complete without some mention of the tremendous changes in the exchange industry.  The icing on the cake came on December 19, when NYSE seat holders voted overwhelmingly in favor of a proposed merger with the electronic trading network, Archipelago, effectively ending the NYSE's 212-year history as a non-profit institution and preparing it for a public listing in 2006.  You can't blame NYSE seat holders for approving the merger: Seat prices on the exchange are up 250 percent since news of the merger broke earlier this year.

Indexing and ETFs were at the center of the deal, as Archipelago brought to the NYSE a central position in ETF trading and leading technology for the listings market. The move paid off quickly - BGI announced plans to transfer the listings of 80 of its iShares funds to the newly combined "NYSE Group" shortly after the merger was announced.

2005 saw the International Securities Exchange and the Chicago Board of Trade go public; the Amex wrestle control of itself back away from the NASD and launch a new trading system; Archipelago snap up the Pacific Exchange; and the Philadelphia Exchange completely reboot its trading system and emerge as a real alternative in the options marketplace.

One of the factors driving these changes is the new Regulation NMS, an SEC regulation requiring all exchanges to be fast and … essentially … electronic.

ETF Battle Lines Are Drawn

Maybe the biggest news in the ETF industry this year was Barclays Global Investors' (BGI) decision to transfer the listing of 80 iShares funds from the American Stock Exchange to the new NYSE Group.  The first of these funds made the leap in December.

Losing the iShares listings was a mighty blow to the struggling Amex, which had positioned itself as the leading exchange for ETFs, and was relying on ETFs to help fuel its recovery.  The Amex has responded by allying itself closely with arch-BGI-rival Vanguard, listing both Vanguard's ETFs and options on those ETFs on its new "hybrid" exchange.

State Street, Vanguard Gird for Battle

Vanguard, meanwhile, looks like it's gotten serious about its ETF effort.  After years of hemming and hawing on the ETF front, Vanguard slashed fees on its VIPERs ETFs in April, making them the lowest cost funds in the Vanguard line-up. As if to prove that they're serious about the ETF market, Vanguard actually patented their unique "share class ETF" structure a few months later.

State Street, meanwhile, looked like it finally tired of playing second fiddle in the ETF market to BGI. SSgA bought the marketing rights for the SPDRs fund in November, and launched the first major expansion of their ETF line-up in years.   SSgA now offers a full line-up of style- and capitalization-based ETFs for the first time in its history, and is expanding rapidly into the sector market. 

BGI isn't exactly slouching on the job - they're expanding their line-up and growing their asset base quickly too, with recently announced plans for a spate of micro-sector funds.

BGI and SSgA were the #1 and #2 asset gathering fund groups in the world in November, pulling in $7.1 and $6.4 billion, respectively.   Vanguard was #4, at $3 billion.  The game is decidedly on.

And Speaking of Battles

Speaking of battles, who can forget the legal tussle between ISE, Standard and Poor's and Dow Jones, which came to a head on September 1.  ISE claimed that it could launch options on S&P and Dow Jones' ETFs without a license … and after much debate, a judge agreed!  That ruling threatens to tip the entire apple cart for index licensing, and you can be sure the appeals process will be watched closely.

Styles Change

Styles change all the time, but they changed for good in 2005, when S&P dropped their S&P/Barra style indexes in favor of fancy new metrics developed in partnership with Citigroup. The new S&P/Citigroup style indexes replace the simple S&P/Barra formula - which looked only at a company's price/book value to determine whether a company belongs in the "growth" or "value" camp - with a complicated seven-part equation.  The new indexes took over as the "official S&P style indexes" on December 19.

S&P actually launched two sets of style indexes as part of its style makeover: the "Style" series, which divides all the stocks in a given universe into equal "value" and "growth" camps; and a "Pure Style" series, which places 1/3 of all stocks in the "growth" camp and 1/3 in "value," and then ignores the muddling middle.  The existing iShares style ETFs have transitioned from S&P/Barra to the S&P/Citigroup Style index series, while Rydex plans to launch "Pure Style" ETFs in the near future.

S&P To Expense Options

Perhaps the most under-reported story of the year in 2005 was S&P's decision to begin expensing options in 2006.  S&P has been offering "core" earnings metrics that look at options expenses since 2001, but beginning in 2006, all earnings measures tallied by the S&P - core, as reported and operating - will include options expenses.

That shouldn't have any impact on people's valuation of the market, as it will only change the accounting of the situation.  But a whole lot of people use the price/earnings ratio of the S&P 500 as a gauge for the relative value of the market, and beginning next year, that's gauge is going to shift.

S&P says: "The impact of option expensing on the Standard & Poor's 500 will be noticeable, but in an environment of record earnings, high margins and historically low

operating price-to-earnings ratios, the index is in its best position in decades to absorb the additional expense."


But that doesn't mean that it's not going to hurt

And More…

And really, that's just the tip of the iceberg.  2005 also saw Standard and Poor's transition its indexes to free float - a move which went off almost without anyone noticing, to the huge credit of S&P.  And we saw some big names move around the indexing industry, such as former SSgA ETF head Gus Fleites, who left (or was pushed) from the Boston-based asset manager and eventually landed at ProFunds.

We also saw currency ETFs hit the market in the U.S., with the launch of a new fund tied to the Euro; leveraged ETFs hit the market in Europe; and continued stirrings of true "active" ETFs in registration at the SEC.  On the "active indexing front," Jonathan Steinberg's WisdomTree Investments made a huge amount of noise, signing an all-star roster of ETF and indexing talent and promising to launch new funds that will beat the averages … although there's no word when or if those funds will actually make it to the market.

Russell and others finally launched micro-cap indexes (and ETFs followed), dividend indexes multiplied into every corner of the market (even S&P got in on the game), and socially-screened ETFs made their long-awaited debut in the United States.

And, of course, S&P added the revitalized Internet poster boy, Amazon.com, to the S&P 500 - and in a telling development, no one batted an eye.

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