A Digression on Program Trading and Derivative Instruments
Whenever the stock market moves sharply one can be sure that financial commentators and even many market professionals will attribute the change to computer “program trading” or to related activities in the futures and options markets. These markets, where one can purchase an option not only on a single stock but also on a whole stock index (or where one can buy a basket of stocks for future delivery), are called derivative produc markets because they derive their value from the value of the underlying stocks themselves.
Commentators invariably suggest that the proliferation of futures, options, index arbitrage, and program-trading strategies is responsible for dramatic increases in short-term stock-price fluctuations. Analysts now even question whether a useful economic role exists for these instruments. In 1935, John Maynard Keynes delivered a warning that is often repeated today: “When the capital development of a country becomes a by-product of a casino, the job is likely to be ill-done.” In late 1989, several of the major Wall Street houses made public pledges that they would eschew program trading in the future in an attempt to dampen market volatility and the New York Stock Exchange announced strict limits on the practice.
Before we rush to accept the conventional wisdom, it is important to recognize that derivative products can play a useful in security markets. These instruments have flourished as a hedge against a perceived increase in basic economic uncertainty. Stock-index futures and options can provide important risk-reducing benefits.; they can be used as hedging vehicles and as inexpensive means of tracking and adjusting positions in underlying assets. By selling index futures against long positions in relatively few stocks, investors avoid the risk of general market fluctuations while concentrating on the prospects for particular companies.
Futures and options also reduce transactions costs since brokerage costs are lower in the futures market than in the stock market. Institutions engaged in temporarily changing a portfolio’s equity mix or in providing some “insurance” against market declines can do so at a lower cost by using futures and options rather than by purchases and sales of the underlying securities themselves.
One of the reasons I am particularly sorry to see program trading get such a bum rap is that the technique results in part from the increasing tendency of institutional portfolio managers to follow the precepts. As a careful reader knows, I have long been an advocate of so-called passive portfolio management. I am very suspicious that portfolio managers can add value by actively managing investment funds and switching from security to security in an attempt to catch good buying and selling opportunities. Two-thirds of active portfolio managers have consistently been outperformed by the unmanaged Standard & Poor’s 500-Stock Index. Hence, a strategy of simply buying and holding the index (as is done by many so-called index funds) can be expected to produce not average but actually above-average performance.
Program trading is the technique whereby index funds can add or subtract funds from their invested portfolios. When a pension fund which indexes its investments receives a new inflow of funds, it can invest them by simply putting in a program-trade order through a computer for simultaneous purchase of all the stocks in the S&P 500-Stock Index. Program trades of this type are now common on Wall Street and the obviouosly influence securities prices. In my view, this represents a very healthy development that has improved the effectiveness of portfolio management.
Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.