Program trade involve the buying and/or selling of a large number of names simultaneously. Such trades are also called basket trades because effectively a “basket” of stocks is being traded. The NYSE defines a program trade as any trade involving the purchase or sale of a basket of at least 15 stocks with a total value of $1 million or more.
The two major applications of program trade is asset allocation and index arbitrage. With respect to asset allocation trades, some examples of why an institutional investor may want to use a program trade is deployment of new cash into the stock market; implementation of a decision to move funds invested in the bond market to the stock market (or vice versa); and re-balancing the composition of a stock portfolio because of a change in investment strategy. A mutual fund money manager can, for example, move funds quickly into or out of the stock market for an entire portfolio of stocks through a single program trade. All these strategies are related to asset allocation.
The growth of mutual fund sales and massive equity investments by pension funds and insurance companies during the 1990s have all given an impetus to such methods to trade baskets or bundles of stocks efficiently. Other reasons for which an institutional investor may have a need to execute a program trade should be apparent later when we discuss an investment strategy called indexing.
There are several commission arrangements available to an institution for a program trade, and each arrangement has numerous variants. Considerations in selecting one (in addition to commission costs) are the risk of failing to realize the best execution price, and the risk that the brokerage firms to be solicited about executing the program trade will use their knowledge of the program trade to benefit from the anticipated price movement that might result in other words, that they will front-run the transaction (for example, buying a stock for their own account before filling the customer buy order).
From a dealer’s perspective, program trade can be conducted in two ways, namely on an agency basis and on a principal basis. An intermediate type of program trade, the agency incentive arrangement, is an additional alternative. A program trade executed on an agency basis involves the selection by the investor of a brokerage firm solely on the basis of commission bids (cents per share) submitted by various brokerage firms. The brokerage firm selected uses its best efforts as an agent of the institution to obtain the best price. Such trades have low explicit commissions. To the investor, the disadvantage of the agency program trade is that, while commissions may be the lowest, the execution price may not be the best because of impact costs and the potential front-running by the brokerage firms solicited to submit a commission bid. The investor knows in advance the commission paid, but does not know the price at which the trades will be executed. Another disadvantage is that there is increased risk of adverse selection of the counter-party in the execution process.
Related to the agency basis is an agency incentive arrangement, in which a benchmark portfolio value is established for the group of stocks in the program trade. The price for each “name” (i.e., specific stock) in the program trade is determined as either the price at the end of the previous day or the average price of the previous day. If the brokerage firm can execute the trade on the next trading day such that a better-than- benchmark portfolio value results, a higher value in the case of a pro- gram trade involving selling, or a lower value in the case of a program trade involving buying, then the brokerage firm receives the specified commission plus some predetermined additional compensation. In this case the investor does not know in advance the commission or the execution price precisely, but has a reasonable expectation that the price will be better than a threshold level.
What if the brokerage firm does not achieve the benchmark portfolio value? It is in such a case that the variants come into play. One arrangement may call for the brokerage firm to receive only the previously agreed upon commission. Other arrangements may involve sharing the risk of not realizing the benchmark portfolio value with the brokerage firm. That is, if the brokerage firm falls short of the benchmark portfolio value, it must absorb a portion of the shortfall. In these risk sharing arrangements, the brokerage firm is risking its own capital. The greater the risk sharing the brokerage firm must accept, the higher the commission it will charge.
The brokerage firm can also choose to execute the trade on a principal basis. In this case, the dealer would commit its own capital to buy or sell the portfolio and complete the investor’s transaction immediately. Since the dealer incurs market risk, it would also charge higher commissions. The key factors in pricing principal trades are: liquidity characteristics, absolute dollar value, nature of the trade, customer profile, and market volatility. In this case, the investor knows the trade execution price in advance, but pays a higher commission.
To minimize front-running, institutions often use other types of program trade arrangements. They call for brokerage firms to receive, not specific names and quantities of stocks, but only aggregate statistical information about key portfolio parameters. Several brokerage firms then bid on a cents per share basis on the entire portfolio (also called “blind baskets”), guaranteeing execution at either closing price (termed “market-at-close”) or a particular intra-day price to the customer. Note that this is a principal trade. Since mutual fund net asset values are calculated using closing prices, a mutual fund that follows an indexing strategy (i.e., an index fund), for instance, would want guaranteed market-at-close execution to minimize the risk of not performing as well as the stock index. When the winning bidder has been selected, it receives the details of the portfolio. While the commission in this type of transaction is higher, this procedure increases the risk to the brokerage firm of successfully executing the program trade. However, the brokerage firm can use stock index futures to protect itself from marketwide movements if the characteristics of the portfolio in the program trade is similar to the index underlying the stock index futures contract.