Program trading of equities: Renegade or mainstream?

Abstract

T he 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 intercountry 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.