Basket Securities - The Future of Stock Trading?

Content

1. Introduction

2. Definition Basket Securities

3. The ideal basket vehicle

4. Types of Basket Securities
4.1 Mutual Index Funds
4.2 Stock Index Futures
4.3 Exchange traded funds
4.3.1 Standard & Poor’s Depository receipts
4.4 Participations
4.4.1 Participation Units
4.4.2 Discount Participations
4.5 Program Trading

5. Conclusion + Outlook

6. References

1. Introduction

Harry M. Markowitz developed the most renowned capital market theory of the last century, for which he received the Nobel Prize in 1990, the “Modern Portfolio Theory”, which can be seen as the basis for basket securities. He recommended investments in diversified portfolios in order to reduce risk.^[1]

Especially institutional investors started to trade large diversified bundles of shares in order to construct efficient portfolios. Soon they recognized, that they need to find an alternative with lower transaction costs and lower potential to destabilize the market than the conventional program trading.^[2] Trading baskets that include all stocks, with narrow spreads and liquid markets, appeared to be a solution.

As a result at the beginning of the 70s the first index funds were issued in the USA, based on the assumption, that actively managed funds are not able to outperform the market in the long term.^[3]

Those funds are intended to avoid the costs of program trading that occurred every trade and meet the needs and expectations of the investors. Due to the instant success, several instruments were created.^[4]

In the following pages I will point out how an ideal basket vehicle should be designed and afterwards examine some of the most popular basket securities concerning the question how good they meet their target of replicating their underlying index and at which price.

2. Definition Basket Securities

A basket security represents an underlying quantity of weighted stocks of companies of a certain region or industry. It is formed with the intentions to eliminate non-systematic risk throughout this diversified investment^[5] and to buy or sell them all at once.^[6] Those weighted stocks are usually represented by indices of which the Standard & Poor’s 500 might be the most popular. To trade those baskets, a variety of index products have been introduced.

3. The ideal basket vehicle

The most important characteristics of an ideal basket vehicle according to Mark Rubinstein are:

1. A low tracking error, which means a good replication of the underlying index, basically.
2. The possibility of continuously trading this vehicle.
3. Low creating, trading and holding costs.
4. The absence of a default risk.
5. The accessibility of small enough units to appeal to small investors.
6. Removal of basket-motivated trading away from the individual shares included in the basket.
7. Passing through the voting rights of the securities underlying the basket.^[7]

4. Types of Basket Securities

4.1 Mutual Index Funds

Generally, two types of mutual index funds do exist, open-end and closed-end funds, of which only the open-end funds will be of importance.

Index funds still buy and sell stocks at the stock market but offer a higher execution certainty due to their size,^[8] but there is still an execution an a price risk.

They are holding an inventory of cash to reduce trading activity should the next investor demand a redemption and reduce thereby their transaction costs since they decrease losses due to the bid-ask spread but also lower their replication efficiency.^[9] The trading costs also contain creation costs if deposits and redemptions do not net out^[10] but funds try to reduce those costs by pooling orders and the cash buffer.

Like other basket vehicles buying index funds is cheaper than trading in individual stocks due to the lower bid-ask spread, since the market makers do face less losses at the macro level from trading with informed traders which would have to be included in the bid-ask spread.^[11]

The holding costs, consisting of management fees, which are much lower than those of actively managed funds, and transaction costs that occur when rebalancing^[12] or reinvesting dividends,^[13] are comparatively low as index funds reduce inventory costs due to advantages from economies of scale.^[14]

Index funds are capable of increasing their profits through securities lending, which is not an option for most individual investors, but face thereby a default risk.^[15]

Since the index prespecifies the stock selection, no active management is needed. The fund managers only rebalance the portfolio, which is referred to as passive management. But the question, what the manager is doing doesn’t disappear, as he still has got a certain impact on the portfolio performance, since he decides about the size of the cash buffer and weights up the requirement of a perfect duplication of the underlying index against the transaction costs that would occur when he rebalances the portfolio.^[16]

But although the aim of an index fund is not to outperform the market, some funds were able to outperform the replicated index by selling stocks above market price when a merger occurs for example.^[17]

Despite the above stated positive features, index funds face some serious problems. First of all, a ready intraday market with a series of continuous transaction prices does not exist,^[18] which is different from the ideal basket, although this is for a good reason: to avoid profits at the expense of other investors by selling shares when those are overstated and buy the underlying individual stocks,^[19] index funds are priced only once a day. This constriction decreases the liquidity of the open-end index funds and “should be considered a trading cost”^[20].

[...]

^[1] See Markowitz (1997), p. 102ff

^[2] See Rubinstein (1989), p. 20

^[3] See Fonds professionell

^[4] See Harris (1990), p. 179

^[5] See Trading-Glossary (n0197.asp)

^[6] See Trading-Glossary (b0082.asp)

^[7] See Rubinstein (1989), p. 22

^[8] See Rubinstein (1989), p. 22

^[9] See Harris (1990), p. 181

^[10] See Harris (1990), p. 184

^[11] See Gammill and Perold (1989), p. 14

^[12] See Harris (1990), p. 182

^[13] See Elton et al. (2002), p. 464

^[14] See Rubinstein (1989), p. 22

^[15] See Rubinstein (1989), p. 22

^[16] See Elton and Gruber (1995), p. 689

^[17] See Elton and Gruber (1995), p. 690

^[18] See Rubinstein (1989), p. 22

^[19] See Rubinstein (1989), p. 22

^[20] Harris (1990), p. 183