In 1999 the inception of the euro1 kick-started moves in continental Europe towards investing in the Eurozone and Europe as single entities, rather than on a country-by-country basis. Although country-by-country investing remains strong, with less sophisticated investors often preferring to invest primarily in their own country’s stocks, the EURO STOXX 50 index and futures contract, launched in 1998 and 1999 respectively, have become the most widely used instruments for those seeking to hedge pan-European equity market exposure.
The EURO STOXX 50 index comprises 50 stocks, selected from the Eurozone (the index currently features countries from Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands and Spain). Potential constituents are screened annually for a minimum average daily trading value of US$1 million. The universe from which they are drawn is created by selecting the largest stocks from each of 19 STOXX Europe industry sectors until 60% coverage of each is achieved, then ranking these by free float-adjusted capitalisation and selecting the largest 40. The remaining 10 stocks are selected from pre-existing constituent stocks ranked between 41 and 60. But since this index includes only Eurozone countries it excludes the UK, Europe’s largest market, as well as Switzerland and other smaller markets.
Most market participants agree that they would benefit from a pan-European equivalent to the EURO STOXX 50 index with an equally liquid derivatives contract. Most of the major index providers have produced indices looking to fill the gap, but although some are listed in derivative form, none has established itself in pan-European trading in the same manner as the EURO STOXX 50 has in Eurozone trading.
Instead, at present it is common practice to gain pan-European equity exposure either by trading the underlying stocks or via a combination of index futures or options contracts, based principally on the EURO STOXX 50, FTSE 100 and SMI indices. The latter process is commonly referred to as “synthetic indexing”2. More sophisticated traders also make use of bilaterally negotiated equity swaps which, in turn, can be hedged in the cash or exchange-traded derivatives markets.
Synthetic indexing has certain advantages: the first is the relative simplicity of trading and holding futures, when compared with owning a portfolio of the underlying stocks, particularly when short-term equitisation, asset allocation or speculative trading are involved, since the synthetic route generally incurs far lower costs. The second advantage derives from the taxation of dividends: as futures do not pay dividends, investors that would usually be subject to withholding taxes on dividends avoid them, despite receiving the dividends indirectly via the futures price, which incorporates future dividends expectations. Synthetic indexing does, however, have certain disadvantages: the commission and spread cost of maintaining the derivatives position through the quarterly roll; the tracking error of the derivative contracts when compared with broader benchmarks, which results from their differing underlying constituents, and the possibility of trading the wrong side of the futures fair value spread as it moves due to changes in interest rates or dividend yields.
Trading multiple derivative contracts also requires users to execute on different exchanges, clear in different central counterparties (CCPs) and accept that the underlying indices themselves are calculated by different providers, using different rules and different management processes.
A number of indices exist that endeavour to provide a pan-European alternative to the EURO STOXX 50. The common perception is that the various indices on offer are very similar. However, the indices produced by STOXX (STOXX EUROPE 50) , FTSE (FTSEurofirst 100) and Russell Indexes (Russell BATS Europe “RUBIX” PanEurope60) have distinct differences from the EURO STOXX 50, which should be of interest to market participants looking for a pan-European tradeable index. Futures have been listed on the MSCI Europe index, and therefore that index can be considered tradeable, as well as being incorporated in our analysis, below, as the reference pan-Europe benchmark.