Several exchange and government-sponsored studies of the stock market crash of 1987 pointed, rightly or wrongly, to program trading as one of its accessories. At the same time, they accepted the growing need for financial institutions to trade large diversified portfolios of assets, and they called for innovation to find some means of preserving this benefit while reducing the potential for these trades to destabilize the market. This article examines alternative methods to facilitate simultaneous execution of trades of a large standardized diversified portfolio of stocks.
It is assumed that an ideal market basket vehicle would (1) represent an important component of risk borne generally by investors; (2) have low tracking error; (3) have a continuous market through time; (4) have low creation costs; (5) have low trade execution costs; (6) have low inventory carrying costs; (7) preserve or enhance tax benefits; (8) have full collateralization; (9) pass through voting rights; (10) be offered in small enough unit size to appeal to small investors; (11) have a predetermined long life before forced liquidation or turnover; (12) not provide incentive to manipulate prices illegally; (13) be part of a related system of securities permitting desirable variations in patterns of returns; (14) not be subject to various miscellaneous security regulations; (15) possess a number of desirable trading features; (16) be simply described to potential investors and have readily accessible price quotations; (17) be consistent with existing securities regulation; and (18) remove all basket-motivated trading away from the individual securities comprising the basket.
This framework is used to compare established alternatives—open-end index funds of either the mutual or bank trust variety, stock index futures and program trades—with the recently developed “index participations” traded on the Philadelphia and American stock exchanges and with proposals currently being examined by the SEC—the “market basket securities” of the Chicago Board Options Exchange and the “exchange stock portfolios” of the New York Stock Exchange. One or more of these newer basket alternatives are likely to become the most actively traded U.S. equity instruments. Moreover, the winners of this competitive experiment in market innovation will set standards for basket trading of foreign equities and other types of securities.
