Monetary and fiscal policy seem to change daily with potential storms on the horizon as the banking sector continues to grapple with the Federal Open Market Committee (FOMC) policy lifting interest rates from near zero to 5%. Market expectations are pricing little policy rate easing by the end of the year, but more next year. Amidst this interest rate environment, equity markets are also facing higher, albeit easing, inflation, low unemployment, and plentiful job offerings as indicated by the JOLTS report. Concurrently, Congress and the U.S. Treasury are negotiating over debt ceiling policy that threatens a U.S. debt default on or after “early June.”

Year-to-date in 2023, equity indices have responded in varying manners. The Nasdaq-100® is off to a roaring start, up over 20% at the end of the first quarter while the Russell 2000® has oscillated between gains and losses over the course of the quarter. Meanwhile the S&P 500® and the Dow indices have posted positive results in the single digits.

Fundamentally understanding the build of the indices helps to uncover the nuances of the several items driving differences in returns in these indices such as dispersion, correlation, and value versus growth, all of which help instruct index choice for market participants.

Each equity index has unique and well-documented methodologies with strong oversight to ensure compliance. The indices characteristics are unique and provide different attributes:

• The S&P 500 Index “measures the performance of the large-cap segment of the U.S. market.”¹
• The Dow Index is “a 30-stock, price-weighted index that measures the performance of some of the largest U.S. companies.”²
• The Nasdaq-100 Index “is designed to measure the performance of 100 of the largest Nasdaq-listed non-financial companies.”³
• The Russell 2000 Index “measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000®.”^{4 5}

The differences in the thematic expressions of these four indices can be better understood through segmenting each index into the common Global Industry Classification Standard (GICS) sectors. GICS is “designed to meet the needs of the investment community for a classification system that reflects a company’s financial performance.”⁶ This sector level detail captures some critical differences between the indices.

With such a broad index, it can be hard to find specific observations that drove returns, but some underlying factors can be identified. The small-cap Information Technology sector performed incredibly well with 16 constituents (mostly Information Technology) doubling in value year-to-date. Like the Dow, the small-cap constituents in the Healthcare sector have underperformed, but to a lesser degree in the Russell 2000. The Russell 2000 is the index with the largest exposure to Financials and Industrials, two sectors that have performed better given higher interest rates and volatility.  

The S&P 500 Index represents a broad segment of large cap stocks and has managed a slightly positive performance year to date. In general, the individual sectors have traded with enough dispersion that they have thus far netted out and produced a smaller overall positive result. For those that more exclusively focus on the S&P 500 Index, consider S&P Select Sector futures, which can help further refine specific sectors that one may seek to enhance or hedge.

Assessing the strength of the relationship of the movements of indices can provide additional insights and help drive index selection. Index correlation is a dynamic measure that changes both over time and the unit of time measurement (i.e., daily for a month or weekly for a year).  

Appreciating dynamic correlations helps identify opportunities in different indices and guide risk management. When indices have lower correlations to one another, the relationship of movements between indices will be lower. This diversification effect can allow higher deployment of capital. Alternatively, a trader could use correlation movements along with spread levels to employ equity intermarket spread trades.

Current correlations between the indices are quite high. However, over the prior year, the Dow has demonstrated a much lower correlation with the other indices. Exhibit 3 highlights current correlations versus prior lows, which occurred in April 2022 for the Nasdaq-100® and S&P 500,® and June for the Russell 2000®.

Watching this space for correlation and diversification opportunities may prove invaluable. 

While correlation is a measure of the strength of the relationship in movements between indices, dispersion is a measure of the magnitude of returns. Suppose one observed two indices that had high correlation, but a different magnitude in return dispersion. Ideally one would favor a long futures position in the index that displayed higher positive returns and eschew, or short as a spread trade, the correlated index that presented a lower magnitude of returns. Dispersion is a critical additional tool combined with correlation and index selection that can drive more powerful returns.

Option trading on Equity Index futures can also benefit with dispersion analysis. If one’s dispersion analysis indicates a potential large dispersion, but option markets have priced implied materially lower volatility, a trader could position for an increase in volatility through a straddle or strangle trade. Dispersion analysis opens all facets of new windows into equity index selection.

To visualize equity index dispersion, a histogram of returns is extremely helpful. Exhibit 4 shows that in 2002 the four main indices followed a Gaussian normal distribution of daily returns. However, there are several interesting observations.

• The Nasdaq-100 Index has thick tails (kurtosis). One could use deep out of the long option strategies to hedge a portfolio with puts or position for upside opportunities with calls using E-mini Nasdaq-100 futures.
• The Dow and to a lesser, but still reasonable extent the S&P 500, both demonstrated many smaller daily returns (plus or minus 0.50%). One may want to monitor the indices against market pricing in options to take advantage of potential breakout moves or sell volatility if markets priced materially higher moves.
• The Russell 2000 demonstrated a larger number of greater than 2% return days compared to other indices. Upside contained option strategies such as call spreads using options on E-mini Russell 2000 futures can be a trade strategy to potentially capture these moves.

Dispersion, like correlation, can uncover valuable market insights and CME Group Equity Index futures and options provide the tools to position for potential moves.

Price to earnings (P/E) ratios moved dramatically over the prior five years across all indices. Spurred by easy monetary policy as a response to the pandemic, P/E ratios for the Dow, S&P 500®, and Nasdaq-100^® (growth) rose between 15 and 20 in price to earnings (P/E) percentage points higher from March 2020 to March 2021. For the Russell 2000 ® (value) the amplitude of movement was even more extreme as the index sextupled and peaked at the beginning of 2021. All indices reverted to their pre-pandemic levels by the middle of 2022 as FOMC policy moved from easy to restrictive levels to contend with stubborn inflation and strong employment figures. 

Assessing the strong movements in the Russell 2000 by decomposing price movements and earnings estimates highlights the material impact of market expectations of FOMC policy and the subsequent earnings recovery. Exhibit 6 shows the progression of the doubling of the Russell 2000 Index over 2020 from its initial March low. Earnings estimates as calculated by Bloomberg plummetted and did not recover until the first quarter of 2021, at which time they adjusted to their pre-pandemic levels. Earnings per share continued to move higher in 2022, but price levels then moved lower as FOMC interest rate levels impacted the Russell 2000, similar to other indices.

The Nasdaq-100 Index P/E ratio moved aggressively higher on a nominal basis as the Dow trended sideways while the Russell 2000 Index nominal P/E ratio trended down. The rapid price gains of the Nasdaq-100 Index resulted in a large gap opening between its calculated level and its three-month moving average. Over the prior five years, this is one of the larger and longer gaps that has opened. In comparison, the nominal P/E ratio levels of the Dow and Russell 2000 are equal to their three-month moving average.

While many items affect the growth versus value story, clearly FOMC policy expectations and changes have been a common attribute across all indices. The key distinction is that the indices have often priced and reacted differently, and it is these differences that can lead to investment and trading opportunities.

The indices are dynamic and have either regular periodic reconstruction (constituent selection) and rebalances (weighting changes), except for the Dow, which rebalances and reconstitutes on an “as-needed” basis.

The Dow has a qualitative selection of firms that meet criteria to be included in the index and then are weighted equally. The S&P 500 reconstitution occurs in September while the Nasdaq-100 is in December. Both are rebalanced quarterly on a March/June/September/December cycle. The Russell 2000 constituents are selected and rebalanced annually in June. During known rebalance dates, equity volatility can elevate as risk positions are transferred in and out of index tracked investments.

The next two quarterly and annual reconstruction and rebalance dates are provided in Exhibit 8 with key distinctions for each index noted. Footnotes are provided for additional insights into the index methodology constructions.

Clearly index selection matters. Today’s ongoing fiscal, monetary, and macro events have made index selection much more important. CME Group provides futures and options on these and many other indices for traders and investors to help manage risk accordingly. Whether one selects to focus on fundamental factors or correlations, the CME Group futures and options contracts on the four major U.S. equity indexes provide market participants with the tools to help manage risk or capture thematical expressions.

¹ S&P Dow Jones Indices, S&P U.S. Indices Methodology

² S&P Dow Jones Indices, S&P

³ Nasdaq Index Methodology, Nasdaq-100 Index, NDX

⁴ FTSE Russell, Index factsheet, Russell 2000 Index

⁵ FTSE Russell, 2023 Reconstitution Calendar

⁶ MSCI Barra, Standard & Poor’s, Frequently Asked Questions about GICS