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Page 4 of 7
As of the end of 2006, there was $1.32 trillion in assets linked to the S&P 500 while the index had a total market capitalization of $12.73 trillion. Thus, for each stock in the S&P 500 roughly 10.34% of its shares were held in products linked to the index. The capacity of the S&P 500 EWI is constrained by the smallest stock in the index.
As of the end of 2006, the smallest stock had a market cap of $1.41 billion. Applying the 10.34% ratio to this it can be estimated that at least $145 million can be linked to the smallest stock in the S&P 500 EWI without resulting in capacity issues. Since each stock in the index represents .2% of the index, this implies that $72.8 billion can be linked to the index without any optimization. If stocks below $2 billion in market capitalization (currently only 5 stocks) are optimized, the capacity reaches $100 billion. However, as noted above, there were only $8.5 billion in assets linked to the index as of the end of 2006, suggesting that assets can increase by tenfold before reaching the level of index effect seen in S&P 500 index changes.
PERFORMANCE OF THE S&P 500 EWI
Exhibit 7 illustrates the performance of the S&P 500 EWI relative to that of the S&P 500. Since inception in 1990 the S&P 500 EWI has outperformed by 1.5% per year. However, the level of outperformance or underperformance has varied considerably over time in line with different market cycles. The S&P 500 EWI outperformed in the early 1990s but lagged the S&P 500 for six straight years from 1994 through 1999, significantly underperforming during the technology bubble of the late 1990s. The S&P 500 EWI significantly outperformed during the correction from 2000 through 2002 and beat the S&P 500 for seven consecutive years through 2006. Although the historical data for the S&P 500 EWI comprises only one major bull market and correction, the performance of the index over this time suggests that equal weighting may underperform relative to market cap weighting during strong markets but will correspondingly hold up better during bear markets.
Exhibits 8 and 9 graph the historical volatility of the S&P 500 EWI and the S&P 500 and the correlation between the two indices. The volatility of the S&P 500 EWI, as measured by rolling three-year annualized standard deviations, exceeded that of the S&P 500 from 1992 through 1995, although the difference in volatility decreased over that period. For the next five years the volatilities of the two indices were very similar. However, the volatility of the S&P 500 EWI spiked relative to the S&P 500 in late 2002 and has remained between 1.5% and 3.5% higher than that of the S&P 500 since that time.
The correlation between the two indices, as measured by rolling 36-month returns, has for the most part consistently stayed between 93% and 96%. The one major exception to this was the technology bubble of the late 1990s and the following correction. During this time correlation was much lower between the two indices than during the rest of the history of the S&P 500 EWI. It reached a low of 84% in late 2001.
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