THE JAWS OF VICTORY
Presented at the Fifth
Annual CME London Finance Symposium,
Le Meridien Piccadilly Hotel,
November 13, 1989.
The fallout from the 1987
stock market crash lasted nearly two years. The debate became ugly
before it got better. Index arbitrageand consequently futureswere
blamed for nearly all the ills of the stock market and beyond. Futures
markets were innocent of blame. The underlying problem was not with
index arbitrage or program trading, but with modern equity investment
techniques and their impact on traditional investment strategies.
latest trend in portfolio management utilized index enhancement
strategies, techniques that required constant adjustments to portfolios
and utilized stock index futures markets. Unfortunately, these portfolio
adjustments caused price movements (volatility) in individual stocks
that had no relationship to fundamental values. As a result, futures
were perceived to be the cause of volatility in the market. The
issue became quite serious and threatened the life of the stock
index futures contract.
Today, I plan to address the
subject of program trading, particularly the aspect of it known
as index arbitrage. It is a subject that unfortunately has become
a somewhat heated topic in U.S. financial circles. While this American
debate may sound peculiar and insignificant to the outside world
of finance, it is even more profound than a surface examination
will divulge. The issues unfortunately include some serious anti-free
market implications. One cannot therefore help but muse that we
Americans have chosen a rather strange moment in history to question
our successful market philosophies. For we stand at the historical
juncture when the triumph of capitalism and free market economics
is undeniable and nearly worldwide. Perhaps the debate is only indicative
of a U.S. penchant to snatch defeat from the jaws of victory.
There are four kinds of program
trades. The first three types do not require stock index futures
and use futures only when they meet the objectives in a cost-effective
The first and most general
form of program trading is defined by the New York Stock Exchange
(NYSE) as "the simultaneous placement of buy or sell orders for
a portfolio of at least fifteen different stocks valued at more
than $1 million." A broker executes these transactions using DOT,
the NYSE automated stock order-routing system. DOT, which requires
computer utilization, has greatly increased the efficiency of stock
Portfolio insurance, the second
type of program trading, is also known as dynamic hedging. This
technique sometimes utilizes the futures market and is effectuated
whenever the cash market index falls to a predetermined level. Though
this strategy was found somewhat inadequate during the 1987 stock
market crash, it is beginning to make a comeback. Its alleged inadequacy
during the crash was likened to an attempt to buy fire insurance
after one's house is on fireit can become rather expensive.
Tactical asset allocation,
the third program trading strategy, examines the relative value
of stocks, bonds and cash equivalents. A pre-determined formula
makes trading decisions in an attempt to achieve the highest yield
for an investment portfolio by exchanging one asset for another.
This strategy has been gaining popularity steadily with many money
managers worldwide. Programmed computersincluding the NYSE's
DOT systemas well as futures and options markets can be and
often are utilized to effectuate this strategy.
Index arbitrage, the last category
of program trading, is the strategy that is usually called into
question and is the topic of the current debate. Traditional arbitrage
activitynot to be confused with that of risk arbitrageis
as old as markets themselves. Not only is there nothing sinister
about the activity, but it greatly benefits the markets with which
it interacts by adding liquidity and equalizing price differentials.
Simply explained, arbitrage works this way: if the widget market
in New York is higher priced than the widget market in Chicago,
an arbitrageur willafter accounting for transportation costssell
New York widgets and buy Chicago widgets, and vice versa.
In index arbitrage, an arbitrageur
monitors both the equity cash market at the NYSE and a stock index
futures such as the S&P 500 contract at the Chicago Mercantile
Exchange. On the date the futures contract expires, its price will
converge with the underlying stock cash price. However, during the
life of the futures contract its price will often differ from the
cash market. Whenever the futures and cash index price differ by
any appreciable amount, an arbitrageur can lock in a profit by buying
the lower-priced market and selling the higher-priced market. It
is an age-old and totally legitimate practice which offers an arbitrage
profit from price differences that develop between two or more markets.
In the case of equities and futures, the price differential results
because futures markets react quicker to market information. The
reason is that futures markets are more cost-efficient than their
counterparts in the cash market.
Quite often, when money managers
want to quickly adjust their portfolio, they will choose to initiate
the indicated transaction in futures. This will cause the futures
market to achieve a different price level than the cash market.
The transitory price difference offers the index arbitrageur an
opportunity for profit. His resulting arbitrage activity works to
even-out the price differential between the two markets. The practical
problem occurs whenever such activities result in a lower price
for the stock market, a consequence of an arbitrage-related sell
program. To someone in the cash market it looks as if the arbitrage
activity is depressing the stock market. Then there is then a hue
and cry against program trading. Conversely, there are few complaints
when the result of such arbitrage activities result in a higher
price for the stock market. As former Treasury Undersecretary, George
D. Gould, explained, "futures markets act as the messenger." When
the message is good, everything is lovely; but you know what happens
to the messenger of bad tidings.
In 1987, the attack against
program trading as one of the primary causes of the crash, took
on the proportions of a witch hunt and proved without merit. Not
one of the 77 post-market studies on the crash found evidence to
substantiate this belief. Today, the attack has somewhat of a different
focus: program trading causes volatility and volatility is driving
the individual investor away from the market. Whether there is more
volatility today or not, whether volatility per se is good
or bad, whether it is driving individual investors from the market,
and whether or not it can be stopped are all important questions
of yet another dimension. Indeed, there is much evidence to suggest
that, when measured over long periods of time, there is no greater
volatility today than years ago. Nevertheless, the issue before
us is whether program tradingspecifically index arbitrageis
the primary cause of volatility in the market.
There can be no dispute that
volatility and liquidity are related. The more liquid the market,
the less the volatility. One could then assume that since volume
at the NYSE and other markets has grown substantially over the years,
liquidity has benefited as well. However, in a letter to clients,
Stanley B. Shopkorn, Vice Chairman of Salomon Brothers, explained
why this is not the case. Mr. Shopkorn focused on a factor of volatility
that is little discussed and may be structural to the marketplace.
Stock market liquidity, Shopkorn states, comes from two traditional
sources: specialists and block trading firms.
As a consequence of the removal
of fixed commission schedules in the mid-1970s, both specialists
and block traders suffered a dramatic decline in their commissions
and floor brokerage. Transactions that would have brought a broker
$.40 a share in the 1960s might bring less than $.04 a share today.
This has had devastating consequences to liquidity. According to
Shopkorn, the higher commissions of two decades ago provided a kind
of insurance. Block traders, for instance, "were willing to make
bids and offers that would stabilize the market because at former
commission levels they could afford to provide liquidity during
periods of stress, even if it meant losing money on a specific trade."
This is no longer true. Current commission schedules "offer insufficient
incentive to cover the risks of significant block positions.
Similarly, the drop in commissions
for specialists has forced them to rely heavily on trading. In the
early 1970s, Shopkorn explains, "about two-thirds of the typical
specialist's income came from floor brokerage commissions and the
balance came from trading." Today, the relationship is reversed.
Moreover, the growing reliance by specialists on trading comes in
an environment of increased competition from other markets and has
led to a narrowing of the bid/ask spreads. A narrower spread reduces
the specialist's profit per transaction.
The combined effect of these
dramatic changes in business has increased the risks and reduced
the incentive to provide liquidity in the traditional manner. Thus,
Mr. Shopkorn points out, "low commission levels for block traders
and specialists do not allow them to accumulate a cushion sufficient
to provide the liquidity that becomes so essential for smoothly
functioning equity markets during periods of stress." If this is
so, Mr. Shopkorn has pointed to a structural reason for inadequate
liquidity which, in turn, has a fundamental effect on market volatility.
But this is by far not the
only possible cause of modern day volatility. Today, large institutional
investors control huge sums of money. The decision-making power
by these funds are held not by vast numbers of investors, but by
a relatively small number of portfolio managers. Their investment
decisions often instantaneous and quite often similarcreate
a sudden and much greater impact on the market than would the separate
decisions of thousands of disparate investors. And whether we like
it or not, whether good or bad, is not the issue. Scientific and
technological advancement have forced the world to become highly
specialized, technologically-oriented, and professionala trend
that will not abate and is nowhere more obvious than in finance.
In the United States, investment managers now represent over 33
million mutual fund shareholders and over 60 million pension plan
participants and their beneficiaries. These funds equal $2 trillion
in assets compared with only $400 billion a mere decade ago.
Furthermore, new technologies
have spawned a myriad of new techniques and the ability to apply
them instantaneously. As Mr. Shopkorn states and most experts know,
the majority of today's trading activities are no longer conducted
relative to fundamental evaluations. Current portfolio managers
often apply index enhancement strategies that require adjustments
to portfolios that result in price movements in individual stocks
that bear no relationship to fundamental values. The nation's 200
largest pension funds now have 30% of their assets committed to
some form of indexation.
Another critical factor in
current stock market volatility is the effect of globalization resulting
from the communications revolution. Sophisticated satellites, micro-chips,
and fiber optics changed the world from a confederation of autonomous
financial markets into one continuous global marketplace where information
flows at lightening speed as well as its resulting market applications.
Tangential to globalization
as a factor of volatility is the impact of foreign investors on
our markets. Their forceboth on a long-term and intra-day
basisis an immense and relatively new influence. Japanese
investors alone represented nearly 30% of the $180 billion in U.S.
stock purchases made by foreigners in 1988. In 1983, Japanese investors
accounted for less than 3% of $70 billion in foreign purchases.
Indeed, the U.S. equity market is no longer the dominant force it
was years ago. In 1975, the U.S. accounted for 75% of world equity
markets; today it accounts for only 25%.
Nor can we underestimate the
volatility consequences of today's interest rate and currency fluctuations
or those flowing from LBOs, high risk junk bonds, or the current
massive global debt structure. Indeed, impacts on price stability
in today's global village are quite different from several decades
ago when American markets were fully insulated from competing financial
Today, the financial landscape
of the United Statesas well as that of the worldis considerably
different. If one postulates that the current U.S. stock market
is more volatile, there are plenty of substantive causes from which
to choose. To conclude that program trading is the single or even
most prominent cause is at best simplistic and at worst self-deluding.
Alas, the issue has taken on ominous proportions. Indeed, there
is currently a dangerous environment in the U.S., one that if unchecked
will blame index arbitrageand consequently futures marketsfor
all of the ills of the stock market and beyond. Witch hunts have
a certain undeniable appeal and can serve as a ready answer to affix
blame for a variety of serious problems.
Already there is a strong view
that program trading is weakening public confidence in the market
and that it disrupts capital formation. Already it is an accepted
truth that sell programsexecuted in conjunction with futures
marketsare depressing stock prices. Already there is a view
that this activity is manipulative and that it profits a few institutional
players by taking advantage of individual investors. Already there
is a movement to stop doing business with firms and individuals
that do index arbitrage. Already there is testimony and proposed
legislation in favor of curbing or even banning this market procedure.
In such a climate, it is easy to see how index arbitrage could become
the central villain should the stock market turn bearish, an eventuality
not to be dismissed lightly. How far a step is it then to a presidential
action of the following magnitude:
It has come to my attention
that certain persons are selling short in the commodity market...These
transactions have been continuous over the past months. I do not
refer to the ordinary hedging transactions, which are a sound part
of our market system. I do not refer to the legitimate...trade.
I refer to a limited number of speculators. I am not expressing
my view upon the economics of short selling in normal times, but
in these times this activity has a public interest. It has one purpose
and that is to depress prices. It tends to destroy the return of
public confidence. The intentions to take a profit from the loss
of other people. . .the effect may be directly depriving (others)
of their rightful income. If these gentlemen have the sense of patriotism
which outruns immediate profit, and desire to see the country recover,
they will close up these transactions and desist from their manipulations.
That address was delivered by
President Herbert Hoover on July 10, 1931. Scary stuff, isn't it?
However, the United States
often reaches the brink of disaster before wiser heads prevail.
Indeed, the recent editorial in the Wall Street Journal is
testimony that wiser heads are entering the discussion. The editorial
cautioned that in such complex issues, one should not jump in favor
of conclusions based on popular misconceptions. Blaming computers
will have its price. Exchanges, the WSJ editors correctly state,
have a difficult task in these matters and have the obligation to
strike a balance between maintaining an orderly market and allowing
the market to freely perform its function. Let us hopeas does
the editorialthat if we err, it will be on the side of free
by permission. Excerpted from Melamed on the Markets, by Leo Melamed.
John Wiley & Sons, 1993
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