Index and Portfolio Trading: ETFs, Futures, and Basket Markets (Chapter 23)
Index trading is one of the most important financial innovations of the twentieth century. And after reading Chapter 22 about how hard it is to identify skilled managers, you can understand why.
If you can’t reliably find a manager who beats the market, why not just buy the market? That’s exactly what millions of investors decided to do. Larry Harris explains in Chapter 23 how that simple idea created an entirely new ecosystem of index products, changed how prices form, and made the markets we know today.
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What Are Price Indexes?
A price index is basically an average of the prices of a list of instruments. The instruments in the list are the index components, and they determine the character of the index.
The two main types of indexes are price-weighted and value-weighted.
A price-weighted index is proportional to the sum of the prices of its components. The most expensive stocks have the most influence. The Dow Jones Industrial Average works this way. It started as an average of industrial stocks but now includes finance and services companies too.
A value-weighted index is proportional to the total market capitalization of all components. The biggest companies by market value have the most influence. The S&P 500 is the most famous example. Most indexes today are value-weighted.
There’s also an important distinction between regular indexes and total return indexes. Regular indexes only track price changes. Total return indexes also account for dividends, giving you the true return an investor would get. When comparing manager performance to a benchmark, you want the total return version.
Index Funds: Just Buy and Hold
An index fund is a portfolio designed to replicate the performance of an index. The tracking error is the difference between the fund’s return and the index return. Managers try to minimize this.
Replicating a value-weighted index is surprisingly simple. If your fund is 0.01% of the total capitalization of all index components, just buy 0.01% of the outstanding shares of each component. Price changes in the fund will exactly match price changes in the index. You only need to rebalance when the index changes its component list.
Index funds slightly underperform their target indexes due to friction: transaction costs from dividend reinvestment, handling deposits and redemptions, and rebalancing when the index adds or removes stocks. Management fees also drag performance down. But these costs are small. Passive managers typically charge less than 15 basis points (0.15%), compared to 50 to 100+ basis points for active managers.
And here’s the thing that keeps being true: index funds regularly beat three-quarters of all active managers. This isn’t just an empirical observation. It’s a mathematical implication of the zero-sum game.
Without transaction costs, the value-weighted average return of all portfolios equals the market return. Add transaction costs back in, and the average portfolio return is always less than the market. Active managers trade a lot, so they pay more in transaction costs. As a group, they must underperform.
Harris puts it bluntly: “Active managers do not lose because they consistently buy losers and sell winners. They lose because they consistently buy and sell.”
Why Index Markets Are So Liquid
Index markets are far more liquid than the underlying cash markets. Several factors make this true.
First, index dealers face very little risk from informed traders. Most index traders are uninformed investors. Few people have valuable insights about where the entire market is going. So dealers don’t need wide spreads to protect themselves.
Second, index markets are very active because most people trade the same products. Buyers easily find sellers. And since dealers can turn over their inventories quickly, they face little inventory risk.
Third, trading an index product means arranging just one transaction instead of hundreds. Buying an S&P 500 index fund is one trade. Buying all 500 stocks individually would be a nightmare.
Price changes in index markets generally lead changes in the underlying securities. Index traders focus purely on discovering the price of index risk. Traders in individual stocks have to worry about company-specific risks too. So index markets are faster at incorporating new information about overall market direction.
Program Trading and Portfolio Trading
When traders need to assemble or disassemble actual index portfolios (not just trade index products), they use program trades. A program trade involves submitting many orders simultaneously. The NYSE and SEC define program trades as any set of 15 or more coordinated transactions totaling $1 million or more.
These trades represent about 27% of NYSE volume. Index arbitrageurs account for about 2.4% of total NYSE volume. The rest is other portfolio strategies, many of which are also index-based.
There’s also a market for package trading (or basket trading). Package dealers make firm bids or offers for entire portfolios. You describe your portfolio’s characteristics and they quote you a price, usually expressed relative to the closing value. So a dealer might bid “closing value minus 15 cents per share.” This works because dealers face less informed trading risk with portfolios than with individual securities.
The Index Product Zoo
Index products come in several flavors:
Open-end mutual funds are the simplest. You buy and redeem shares directly from the fund at closing net asset value. But you can’t trade within the day, and the fund has to manage cash for deposits and redemptions.
Exchange-traded funds (ETFs) solve these problems. ETFs are trusts that hold index portfolios, and their units trade like stocks on exchanges. Large traders can create new units by depositing an index portfolio, or redeem units for the underlying stocks. ETFs generate fewer tax liabilities than open-end funds because they don’t buy and sell securities when investors move in and out.
Index futures are especially popular with hedgers and speculators because you can trade them without posting large margins. The downside is rollover: when your contract expires, you need to move your position to a new contract, which generates transaction costs.
Index options round out the product set. Speculators, hedgers, and gamblers use them.
The Russell Reconstitution Problem
Harris highlights an interesting side effect of index investing: when indexes change their components, the buying and selling pressure from index funds can move prices significantly.
The Russell indexes are reconstituted annually at the end of June. Between 1996 and 2001, Russell 3000 additions outperformed deletions by an average of 15% in June. Then in July, they underperformed by 5%. The price impacts are large because Russell 3000 stocks are small, and all the index funds are buying the same additions and selling the same deletions at roughly the same time.
The S&P 500 has similar effects when it changes components. This creates opportunities for order anticipators and price manipulators who can trade ahead of the predictable index fund flows.
The Bigger Picture
The growth of indexing has fundamentally reshaped markets. The nominal dollar value of trading in equity index products is now greater than the total dollar value of trading in the underlying securities. The tail really does wag the dog.
But Harris emphasizes that this is driven by perfectly rational behavior. Most investors cannot identify skilled active managers. Trying to do so with statistical methods requires more data than anyone has. Index funds are cheap, transparent, and they beat most active managers most of the time.
Is indexing “an immoral search for mediocrity”? Harris poses the question but the numbers speak for themselves. Getting the market average is better than what most active managers deliver after their fees and trading costs.
The interesting question is what would happen if almost everyone indexed. If buy-and-hold managers held 90% of all equity, prices would become less informative and opportunities for the remaining active traders would grow. But we’re not there yet, and the economics that drive indexing keep getting stronger.
This post is part of a series retelling “Trading and Exchanges: Market Microstructure for Practitioners” by Larry Harris (Oxford University Press, 2003). The goal is to make these concepts accessible to everyone, not just finance professionals.