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Program trading of equities: renegade or mainstream?

Program trading gained a bad name after the 1987 stock market crash. But it is here to stay with new products coming out all the time.

The strategy of portfolio/program trading of lists of securities simultaneously has been around for some 15 years, but only in the last few has it generated interest and controversy Program trading currently constitutes about 10 percent of a typical day's volume on the New York Stock Exchange and is most commonly used by large institutional money managers, pension funds, and their broker/dealers. Fulfilling many of the same needs as portfolio trades, futures on U.S. stock indexes were introduced in 1982 and now trade a dollar amount of equity value each day about 125 percent of the amount traded on the NYSE. New portfolio trading vehicles have been or are about to be introduced before the end of this year-specifically, Exchange Stock Portfolios and Market Basket Securities which will offer a market for exchanging S&P 500 portfolios as units operated by the NYSE and CBOE.

The controversy surrounding program trading has arisen primarily because of a clash between traditional stock trading as conducted by exchanges and the portfolio approach to investment undertaken by the large institutions over the last decade. Many of the strategies that fit with the objectives and scale of institutional money management, such as indexation, quantitative screening of lists of stocks, asset allocation, portfolio insurance, return-enhancing futures arbitrage, and inter-country portfolio shifts, are most efficiently executed with portfolio trades. Even more compelling to money managers and their ultimate customers is the fact that portfolio trades typically cost one-half what traditional trades cost. Transacting with index futures can reduce costs even further, to 10-20 percent of the cost of a traditional stock trade.

THE COMMODITIZATION OF STOCK MARKETS

Goods and capital have been flowing across borders at an accelerated pace, while the economic prosperity of the 1980s has greatly expanded the value of global stock markets over the last seven years. Current communications technology allows investment information to be transmitted immediately to trading rooms on the other side of the globe and permits investors to act on this information very quickly. The result is the release of new economic statistics or movements in currencies transmitted into the prices of other financial assets more quickly Since futures trading presents a forum for concentrating liquidity with competitive market making, markets in which futures are traded are often the first to react to new developments affecting the values of all equity or fixed-income securities denominated in a particular currency.

Advances in investment theory over the last 25 years have concluded that the risk of a portfolio's general equity market exposure should be separated from the risk of specific stock holdings for purposes of portfolio construction, risk management, and performance evaluation. Portfolios should meet the objective of achieving the greatest risk reduction for a given return level. Such portfolios tend to be well-diversified, often resemble market indices, and thereby effectively view the stock market as a commodity. One-quarter to one-half of the performance of a typical stock can be attributed to movements in the overall market. For a diversified equity portfolio, more than 90 percent of the returns can usually be explained by changes in the general level of a market index.

The first effect of this "Modern Portfolio Theory" has been the acceptance of passive or index management by pension funds and other large institutional investors. If a large portion of returns of equities is a function of overall market factors, it seems to make sense to allocate a portion of an equity portfolio to index management. This is especially true if passive management can be implemented at a much lower cost than active stock selection services. As of the end of 1988, indexed equity assets at money managers surveyed by Pension and Investment Age were $137 billion. Internally managed index funds at pension sponsors easily bring this figure to over $200 billion.

The indexed portions of institutional portfolios, along with futures on those indexes, have in turn become the means through which investors shift among asset classes such as stocks, bonds, and cash. This latter decision, the asset-allocation decision, has been shown to be of critical importance to overall performance and is now often treated separately from the selection of particular issues of stocks or bonds. Retail or individual investors, who have become comfortable with money market funds and bond mutual funds, have also begun to appreciate the import of this critical decision in which the equity portion of holdings is, in fact, treated as a commodity. The availability of international investment vehicles has expanded the range of choices and diversification opportunities for both individual and institutional investors. The impact of the growth of interest in asset allocation and the range of vehicles with which to trade asset classes has had the effect of layering the investment-management process. At one level stocks are considered an asset class or commodity and defined in terms of indices. At another level they are differentiated from one another and compared based on price versus value and appreciation opportunity

The second effect of the application of Modern Portfolio Theory to investment management has been to change the way in which stocks are analyzed and compared to one another. Those aspects of a particular equity issue specific to that company, not related to the overall market, are both of most importance in analysis and the basis for inclusion of that stock in a portfolio. Quantitative approaches to stock selection have become more widespread. In these approaches stocks are compared based on valuation of anticipated cash flows, consistency of earnings growth, and other objective measures. The result of this process is a list of issues to buy and sell periodically that can at times be most efficiently handled via a program trade. Other applications involve index funds with slight tilts or increased weights in "cheap" issues at the expense of lower weights in issues deemed overvalued through some analytical process. These portfolios are often close enough to index holdings to be executed as program trades.

APPLICATIONS OF PORTFOLIO TRADING TECHNIQUES

Before discussing the specific means by which portfolio trades can be accomplished either directly or through derivatives, we will identify some of the aspects of the investment management process in which these trading techniques have proven to be most effective. Figure 1 lists the applications of portfolio and index derivative trading for institutional investors and broker/dealers. For institutions, this form of trading has been conducted in the process of managing the overall fund or pension plan as well as within the specific stock or cash segment of the fund. In addition, portfolio trading, despite its image of appealing primarily to passive or index managers, has begun to play a role in the actively managed segment of the stock portfolio.

Asset Mix Management

At the overall fund level, portfolio trading and index derivatives are most widely used for adjusting the asset mix to changing performance expectations for asset classes or country exposures. For example, a shift from bonds to stocks can be accomplished with Treasury bond and stock index futures or with portfolio trades, thereby increasing the amount held in stock index funds and selling a portion of a bond index fund or the liquid Treasury securities. Another common application would be the use of a portfolio trade to shift from the Japanese stock market to the U.K. stock market by selling stock baskets constructed to replicate a Japanese market index such as the Nikkei 225 and purchasing a U.K. stock index portfolio. Index trading is also used to maintain target asset weights, as relative changes in asset class values cause aggregate stock and bond holdings to drift away from target levels.

The choice between stock portfolio trading and derivative securities for asset class shifts depends on several factors. Tactical or active asset allocation, which attempts to exploit short-term pricing opportunities across markets, is often best implemented with futures. Strategic asset shifts expected to be in place for one year or longer should be implemented in the underlying market with a portfolio trade, thus avoiding the cost of rollovers of futures positions every quarter. Futures have the advantage of enabling the asset mix management to be used in conjunction with the stock, bond, and cash management. Each process can then be handled by a different party, performance measurement can be separated, and more expensive stock trading can be confined to turnover motivated by stock-specific considerations.

Portfolio Insurance

Portfolio insurance implementation is also facilitated by portfolio trading and the use of derivatives. In practice, the trades associated with this strategy are in the same format as asset mix trades except that index options become more important in the execution mix. Since portfolio insurance aims to protect aggregate equity values in an equity market decline, it views the equity portion of the investment portfolio as a commodity. The exposure to the declining market is reduced as prices fall through the selling of assets being protected with futures hedges, by portfolio trades, or by increases in the value of a put option representing the right to sell that equity portfolio for a fixed price. More sophisticated applications of portfolio insurance involve protecting the value of either the spread of pension assets over liabilities or of an equity portfolio denominated in a currency other than the base currency of the component stocks. From the perspective of trading requirements, these other applications are similar. They differ, however, in the circumstances surrounding the value change that triggers the portfolio or index derivative trade.

Applications in Portfolio Administration

Fund administrators also find portfolio trading and derivatives handy when they need to deal with structural changes in their funds or handle large cash flows. Investment managers are shifted, portions of plans or whole plans are terminated, and large pools of cash need to be added or withdrawn. Two things are critical in these types of operations: first, the change needs to be accomplished with minimal disruption to the asset mix; second, the change should be conducted in the most cost-effective manner. With portfolio trading, a stock portfolio can be sold and another repurchased within a day; futures can also be used while stocks are being shifted. The pure commission and market impact cost is often less than half of what would be incurred if stocks were handled individually. In addition, stock trades may take days to implement, over which time performance would be sacrificed on funds held in cash.

Derivatives work particularly well for keeping cash positions at a minimum for large investment portfolios. Cash holdings arising from the normal flow of daily stock transactions can be "equitized" by purchasing index futures representing the aggregate dollar amount of cash balances held. Money managers can thus efficiently maintain fully invested positions.

Passive Equity Management

Portfolio trades are the bread and butter of index fund management, as well as one of the reasons the fee structures for this type of management are so low. Passive management is also growing in other major equity markets. The amount of index investment in Japan is believed to be in the neighborhood of $25-40 billion and growing rapidly. These funds (after subtraction of management fees) typically perform within .25 percent of their target index, taking into account the reinvestment of dividends. The management of index funds primarily revolves around handling cash inflows and outflows, such as dividends, withdrawals, new inflows of funds, and changes associated with restructurings, stock tenders, and index additions and deletions, in an orderly and low-cost manner.

Separate index fund products have been created to exchange index tracking error for enhanced returns. In one application, index fund managers engage in arbitrage between stock index futures and the index portfolio, depending on which is more attractively priced. These enhanced index fund strategies have added from 1 to 3 percent in incremental returns to those generated by indices over the last several years. In addition, this arbitrage between cash and futures markets keeps pricing relationships between futures and stock markets linked. Other enhanced return products for index-based funds that use portfolio trades overweight and underweight certain issues slightly to take advantage of price/value opportunities as identified by some quantitative model. These strategies combine active and passive management but position themselves more closely to index funds.

Active Equity Management Applications

Active equity managers are hired because they promise to outperform an index or other performance benchmark in return for a higher management fee than that collected by passive managers. Many of these managers use computer-based portfolio screening and evaluation techniques to compare the many investment opportunities available to them in equity markets. The result is a periodic list of stocks to buy and sell. When they trade these issues, the managers would like to realize a price as close as possible to the price on which the evaluation was based and coordinate the dollar amounts involved in the sale of one set of securities and purchase of another. These active managers utilize portfolio trades to accomplish their disposal and acquisition of issues. Many have also tried stock swapping services such as Instinet and Posit, which are stock order-matching services that attempt to match buyers and sellers off-exchanges for low commissions.

Recently, active managers have begun to participate in the market-making function often conducted on broker/dealer block desks. Lists that one manager wants to buy or sell are shown by the broker to other managers who have indicated an interest to take the other side of trades offered or bid into the stock market. Knowing that a large quantity of a particular issue is available to be sold may make another manager inclined to buy more of that issue, if it is already considered a target holding for that account. The managers are therefore looking for access to supply and demand information on particular issues. Portfolio trading systems that have procedures for maintaining lists of portfolios are handy for transmission and execution of this inter-manager trading.

Enhancing Cash Returns

The final institutional application is in the cash portion of the portfolio, where stock portfolios hedged with stock index futures are held when they offer prospective returns in excess of benchmark money market rates. Stock index futures at times become overvalued, and an arbitrage trade between the equity and futures market can improve the returns on the cash segment of the portfolio. This strategy is most suitable to institutional investors with funds in indexed equity portfolios. A position in a stock index or bond, hedged with futures, should provide the short-term interest rate in effect until the expiration of the futures contract, taking into account the specific transaction and financing costs of the underlying stock index or bond position. Short-term supply and demand pressures specific to one market (futures or stock/bond) can send intermarket pricing relationships to levels where the implementation of a hedged position can improve returns.

Broker/Dealer Applications

Proprietary trading has become an important part of the revenue of investment banking firms as commission rate pressure has reduced the profitability of customer business. As members of stock and futures exchanges, brokers can implement trades for their own account at low cost. In addition, employees on the floors of these exchanges are able to quickly receive information. As investment professionals, they also have a great deal of expertise and experience in devising strategies to act on this information. Brokers also have direct access to portfolio trading systems they maintain for their customers. Finally, while facilitating customer trades they often acquire inventories of net long or short stock positions or over-the-counter option positions that must be hedged properly.

Portfolio and futures trades by broker/ dealers can therefore be both a part of their normal risk-management function and based on short-term market views developed from their access to information and trade flows. In any dealer market, the availability of hedging vehicles such as Treasury bond futures encourages more competitive market making and willingness to commit capital. Broker/dealers have the objective of maximizing the return of the deployment of that capital, whether it is to be used for customer trade facilitation or for investing firm positions when customer opportunities are not present or offer lower returns. Stock index arbitrage activity by broker/dealers is controversial because broker/dealers have a comparative advantage in the cost of executing the stock portion of the trade. There is also still an impression among many investors, particularly retail investors, that this activity distorts individual stock prices; others feel that existing stock market structures do not have the capacity to handle large amounts of this activity at times of market stress. Therefore, some broker/dealers refrain from proprietary stock index arbitrage with S&P 500 futures for these noneconomic reasons. This abstinence is likely to continue until exchanges develop products and procedures that are better able handle interportfolio and intermarket arbitrage and until the investing public gains a better understanding of the motivation and real impact of these strategies.

PORTFOLIO TRADING VEHICLES AND TECHNIQUES

Up to now we have primarily been discussing portfolio trading in the context of trading lists of stocks using the NYSE automated order entry system (SuperDot) and stock index futures. It is worthwhile to explore the features, advantages and disadvantages of each of these in more detail. In addition, alternative forms of portfolio trading exist, including Exchange for Physicals. Exchange stock Portfolios and Market Basket Securities, new methods of portfolio trading pending approval, are expected to debut soon at the New York Stock Exchange and Chicago Board Options Exchange.

As we have mentioned previously, many experts on financial markets feel the growth of the demand for simultaneous execution of groups of stocks has outstripped the capacity of existing market-making facilities to provide for such execution. This point was brought to light in many of the studies of the October 1987 stock market crash. The markets' inability to handle the large demands for portfolio and index futures trading without severe price adjustment was considered a contributing factor to the crash. However, the role of portfolio trading in the crash is inconclusive given the fact that foreign stock markets, where very little portfolio trading is used, fell as much or more in price.

Nevertheless, the close study of stock-trading behavior that came out of post-crash investigations revealed the importance of such trading techniques to institutional market participants. At the time, several governmental and exchange studies and officials highlighted the need for more portfolio or "basket" trading vehicles, in addition to stock index futures, to minimize the impact of this form of trading on more traditional stock trading practices. The options exchanges (Philadelphia and American) responded with the Index Participation product; the NYSE and CBOE both developed proposals for trading a single unit representing portfolios of securities that would then be delivered through traditional stock-delivery procedures.

Portfolio Trades

The oldest and most established form of portfolio trading, existing since the early 1970s, involves the simultaneous execution of lists of stocks. Market folklore holds that these trades got their name because the contents of portfolios were stored on computers and printed out by running a program before they were given to the floor for execution. Originally these trades were hand-carried to the relevant execution post, but this required a great deal of manpower and incurred significant market risk. (This practice is used even today when other systems are unavailable). In 1975 the NYSE initiated the Designated Order Turnaround (DOT) system, which was designed primarily to handle retail trades of up to 2,099 shares in an individual issue. This system was upgraded in 1987 to SuperDot, which has processing capacity of up to 25,000 shares per issue. Market orders entered into DOT are transmitted electronically to the appropriate specialist post, and executions are reported back to the member firm's trading room in three minutes.

Brokers use DOT to transmit lists of orders required for portfolio execution to the floor and to receive execution reports. They connect the DOT system to their own order processing software to make the handling of these trades even more automatic. Portfolio orders for more than the maximum trade size acceptable by DOT could easily be broken into slices consistent with the system specifications and typical market liquidity. The American Stock Exchange and NASDAQ systems also developed automatic order-routing systems, so an S&P 500 portfolio could be executed within minutes. Portfolio trading through the DOT system is the best means of handling nonstandard baskets, lists of stocks to be bought and sold by active stock managers, and small portfolio rebalancing trades involving reinvestment of cash dividends.

The current capacity of the most sophisticated portfolio trading systems permits broker/dealers to deliver several thousand orders per minute. They can handle other types of orders in addition to market orders, such as limit orders, buy on a minus tick, and sell on a plus tick. Some brokers have permitted direct access to their portfolio trading system to select institutional customers and have added analytics for strategy development and trade-execution evaluation.

Table 1 shows the statistics on portfolio trades at the NYSE utilizing the DOT system for the year ending June 30,1989. On average about 10 percent of a typical day's trading volume was represented by such trades, and about half of these had a related index futures transaction. Some 68 percent of the trades were executed on behalf of customers on either an agency or guaranteed basis; the remaining 32 percent were conducted for the firm's own trading account.

Despite the existence of automated facilities for receiving program trades, the actual market making in equities is still essentially done on a stock-by-stock basis. At the NYSE each specialist has a diversified book of issues, but this book has substantial tracking error relative to an index and cannot be hedged easily with existing index futures contracts. The specialist sees the component parts of a portfolio trade that concern his issues and must treat the portfolio trader in the same way as any other stock order being received via the DOT system. However, in deciding on a price at which to execute the order, the specialist has information relating to the aggregate market and limit order flow in that stock and has more difficulty hedging the execution risk than does the upstairs portfolio market maker or the customer who initiated the transaction. Moreover, two customers (or a customer and broker/dealer) who wish to cross a matched portfolio trade cannot do so while the NYSE is open without the specialist's intervention. Such crosses can occur, however, in large blocks of individual stocks. Recently, the NYSE proposed a new market-on-close order that will allow for crosses to occur at the closing price of each stock.

One of the motivations for the development of new portfolio trading vehicles is to allow for a two-way market to be made in baskets of securities, in which the specialist or market maker will be one participant. With portfolio trades conducted on the DOT system, it is extremely difficult to assess the aggregate amount of portfolios to be bought or sold at various index levels. Better guidance for this supply and demand pressure is provided in the index futures market.

Index Futures Trading

Futures trading on stock indexes began in 1982 when provision for cash settlement of futures was made and the SEC opened the door for derivative securities to trade on portfolios of stocks. A future on the Value Line index was introduced by the Kansas City Board of Trade in February 1982, and one on the S&P 500 was introduced in April 1982. In the U.S., futures also trade on the NYSE index and on the Major Market Index, a clone of the Dow Jones Industrial Average. The S&P 500 future is by far the most actively traded, representing some 85 percent of dollar value of index-derivative trading.

From an institutional perspective, a synthetic index portfolio position can be created by a long position in an index future combined with the holding of a money market instrument. The gains and losses on the futures position should mimic those of an index portfolio. Futures pay no dividends, but the net of the interest earned on the money market portfolio and the dividends foregone by holding the future are reflected in the futures price, so the total returns of the two positions are equivalent when futures trade at their fair value. In the instances when futures trade cheap, the returns of the futures position and money market portfolio should be in excess of what could be earned on a portfolio consisting of the underlying stocks.

On a typical day, the volume of portfolio trading occurring in U.S. futures markets is about 125 percent of the dollar volume of NYSE trading-$74 billion $7.4 versus $6 billion for the first six months of 1989. Since program trades are only 10 percent of NYSE volume, the index futures markets manage a flow of "synthetic" portfolio trades some 12 times that of the NYSE in a trading session. An S&P 500 futures contract represents $165,000 of stock value and (in commission terms) with the S&P 500 at 345 and costs less than 10 percent of the stock commission on a comparable size portfolio trade executed on SuperDot. Therefore, in terms of both cost and liquidity, the index futures markets have a considerable competitive edge as a means of adjusting overall exposure to the equity market.

Futures trading is conducted via open outcry in a trading arena where each competitive market maker owns his own seat. Almost half of the trading activity is intra-day trading by these market makers, a feature very different from the typical stock exchange. Open interest reflects positions open at the end of any trading session and thus is a measure of institutional and retail customer use as opposed to trade facilitation by market makers. Figure 2 shows the average open interest and volume in S&P 500 futures over the last several years. The. growth in open interest shows the increasing use of index futures as a surrogate for long and short S&P 500 portfolio positions.

For asset allocation adjustments and initiation of short-term synthetic positions in the equity market, futures offer ease of execution, much lower execution costs, and leverage when desired. Futures do have some operational disadvantages, however. Because these markets have a separate regulatory structure, futures trading requires a separate account so funds associated with futures trading can be segregated from those used for stock executions. In addition, futures gains are passed daily from losers to winners, placing more cash flow requirements on futures traders than on stock traders-for whom gains and losses are unrealized until the position is closed. Futures also represent only standardized baskets and expire periodically. As a contract approaches expiration, the portfolio manager must decide to switch back into stocks (or cash) when the position expires or roll forward to the next contract. The pricing of the roll or calendar spread trade can work for or against the trader and introduces some risk and reward opportunity to the synthetic index trade with futures.

Index futures trading can now be conducted globally; index futures trade in Japan, the U.K., France, Australia, Singapore (on a Japanese index), Canada, Hong Kong, and New Zealand. The CFRC has not yet approved several of these contracts for U.S. investors, but local money managers have come to use their index futures in much the same fashion as U.S. money managers have become acclimated to S&P futures applications.

Stock Index Arbitrage

The strategy of stock index arbitrage is conducted through offsetting positions taken in index futures and a stock index portfolio to capitalize on discrepancies in the relative prices of positions. When futures are cheap, they are purchased while stocks are sold in what has come to be called a "sell program." The opposite trade, used when futures are "rich," is a substitute for a money market position and involves selling futures against a stock portfolio purchased with a "buy program." Because stock index arbitrage involves both selling and buying index portfolios, there should be no net directional effect on either market in excess of closing the spread between the fair and actual value of the futures contract. Because the stock side of the trade has an uncertain market impact, depending on the number of other orders hitting the flow simultaneously through the DOT system, traders allow for some slippage in deciding when to initiate an order. A shortage of liquidity in comparison to the volume of arbitrage trades attempted to be executed at a particular point in time can result in a price reaction that would also reduce the profitability of the trade. One of the appeals of Exchange for Physical (EFP) trades discussed below is the ability to control the market impact through a two-party matched execution.

Exchange for Physicals in S&P 500 Futures

Another portfolio trading mechanism that has been in use for some time during off-exchange hours is the Exchange for Physicals market. Futures trading rules allow a holder of a futures position to swap out of that position for the underlying instrument at a negotiated basis level (spread between futures and underlying price) after the futures exchange is closed. The trade must occur between two parties and be reported to the exchange where the contract is traded.

The EFP provision has been used by dealers for facilitating customer trades into and out of index futures positions at preset basis levels. The advantage for the customer is that he or she can swap out of a long futures position into an S&P 500 portfolio in one trade knowing the all-in cost up front. The stock part of the trade is crossed in London as a book entry. NYSE rules allow for trading in NYSE issues off-exchange when the NYSE is closed. From the dealer's perspective, a significant advantage in this type of trade is that stocks sold short in exchange for a futures position are not subject to the plus-tick rule in force in the NYSE. There is, however, no central marketplace for EFPs. To find the direct market, investors must survey dealer firms for indications of basis levels that will ultimately be negotiated between the two parties to the trade.

EFPs are quoted in terms of the basis of futures premium over the index. For example, a dealer may be willing to sell stock in exchange for futures at 3.20 S&P points over the index close; alternatively, the dealer may be quoting an EFP trade to sell futures and buy stock at a 3.60 premium to the index. Dealers will typically price their EFP market in relation to the fair value of the future using their financing rate and based on current inventory or risk-management needs. Because the stock side of an EFP trade usually occurs in London, it is not reflected in NYSE volume figures; however, the volume is reported in the program trading statistics collected monthly by the NYSE.

change Stock Portfolios and Market Basket Securities

e NYSE's and CBOE's responses to the call from the SEC for more index-trading vehicles are new trading mechanisms rather than separate investment products. With an Exchange Stock Portfolio (ESP) or Market Basket Security (MBS), a portfolio trade of 500 stocks is effectively executed in a bundle with one order that is settled with physical delivery of 500 stocks.

In the NYSE's version of this product, a group of competing market makers, one of which is the aggregation of specialists' bids and offers, will be quoting bid and ask prices on the S&P 500 index. All market makers will have access to the electronic order book. The benefit of ESPs and MBSs is the availability of an S&P 500 basket to be traded as a single unit in a competitive market-making environment. This should make the market for standard S&P 500 portfolios more efficient and less costly compared to implementation via the SuperDot system.

The ESP will be large (about $5 million) and contain odd lots of S&P 500 issues. As an incentive to create a tight and liquid market, the ESP will not be subject to the plus-tick rule that permits the selling of individual stocks only on prices higher than the last sale. The S&P 500 futures should remain the most liquid, continuous market for portfolio trades and should actually increase in volume with the existence of ESPs. Because of the size of the ESP, it is unlikely that there will be continuous activity in these baskets; rather the facility will be used primarily at the open and close, and for crosses or arbitrage within the trading day Arbitrage bands between the futures and ESP index quote will tend to be narrower because of the ease of executing the arbitrage trade when an explicit underlying vehicle exists. The future will continue to be used by broker/dealers as the natural and lowest-cost hedge for the ESP, much as it is now for an S&P portfolio trade execution.

The success of ESPs and MBSs has yet to be determined. Portfolio trading index futures and stock index arbitrage, having survived the October 1987 market turmoil, now appear well entrenched. Another sign of the permanence of portfolio trading is the eagerness with which non-U.S. investors are using this strategy and index futures markets. A period of change and innovation always brings some striking successes and some dismal failures. New products are rarely accepted with open arms by those involved with the products they replace or whose volume they reduce. The survival of a new product ultimately depends on whether it fulfills a customer need better and at a more competitive price than currently available products. So will it be with portfolio trading services as they continue to experience growth, innovation, and, not surprisingly, controversy.
  Figure 1
  Portfolio and Index Derivative Applications
  Institutional Investor(1 )
    Overall Fund or Plan
    Shifting the asset mix
    Maintaining a target asset mix
    Portfolio insurance
    Moving funds from one manager to another
    Handling large contributions or withdrawals
    Terminating plan
    Stock Segment
        Passive equity management
            Investing cash flows and dividends
            Swapping between stocks and cheap stock index
                    futures
        Active equity management
            Purchasing a list of attractive issues
            Disposing of a list of unattractive issues
            Supplying liquidity to other active managers
    Cash Segment
    Buy stocks and sell futures to create synthetic cash
               (arbitrage)
  Broker/Dealer
      Arbitrage Desk
      Buy index/Sell futures
      Short index/Buy futures
      Block Desk
      Hedge a guaranteed portfolio execution
      Hedge an aggregate equity position
      Risk Management Desk
      Hedge a short or a long OTC index option obligation


1. Pension fund, mutual fund, money manager, insurance, endowment, nonprofit institution.
  Table 1
  NYSE Program Trading Statistics
  Program Trading Relative to NYSE Volume (shares and volume in millions)
       Program                               Traded   Traded in
        Trading  Program   NYSE      Traded   in Other  Foreign
        Shares   Trading   Volume   at NYSE   Markets  Markets
  Average  0.4    10.2%     158.3    76.5%      5.4%    18.1%
  7/88     20.8   10.7%     148.3    76.0%      7.8%    16.2%
  -12/88
  1/89     19.9    9.7%     168.2    77.1%      2.9%    20.1%
  -6/89
  NYSE Program Trading Strategies   NYSE Program Trading by
                                               Source
            Index   Other                     Customer
          Arbitrage                Principal Facilitation
                                                         Agency
  Average  49.3%   50.7%   Average  32.4%       17.3%      50.3%
  7/88      50.2%   49.9%   7/88    27.4%       16.3%      56.3%
                            -12
  1/89      48.5%   51.5%   1/89    37.4%       18.3%      44.4%
  -6/89                     -6/89
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Author:Hill, Joanne M.
Publication:Business Horizons
Date:Nov 1, 1989
Words:5945
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