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SPDRs Are Crawling Their Way Up The Volume Charts

By Robert Hunter

There was nary a blip on the financial radar screen when Standard & Poor's depository receipts (SPDRs) were first listed on the American Stock Exchange four years ago. The product enjoyed decidedly modest liquidity early on, as most investors tried to figure out the advantages of a product that looked almost identical to an S&P mutual fund.

Four years later, things have changed. SPDRs are now the most actively traded instrument on the AMEX, both on a volume and a dollar-weighted basis. Volume has more than doubled in the last year, from an average of roughly 900,000 shares per day to nearly 2.4 million.

Share print runs are routinely in the half-million range, and have been as large as 2 million. Arachniphobes beware: SPDRs may soon take over the world.

The S&P depository receipt is a unit trust made up of the 500 shares of the S&P 500 Index, in roughly the same proportion. It is open-ended—it can be created or redeemed on a daily basis—and pays a quarterly dividend equal to the amount paid by the underlying stocks minus expenses.

Investors of all types are attracted to the products. Although the largest number of trades are by smaller investors, the largest portion of the trading volume comes from large investors. The trend among retail investors over the last several years toward indexation has spilled over to SPDRs, which offer a number of advantages over index mutual funds. Capital gains taxes are far lower for SPDRs than for index mutual funds, and they offer instant access to the market—an advantage for the growing legions of retail investors who, hunched over their office computers, manically track half-point swings in the S&P. And SPDRs' expense rate of 18.5 basis points is 1 basis point lower than its largest competitor, the Vanguard S&P 500 mutual fund.

Institutional investors like the liquidity they offer. "One of the worst things that can happen to you in this market is someone gives you a hundred million dollars,” says Mike Bickford, senior vice president of derivative securities marketing and research at the AMEX. "You get a day when the market's up 175 points, and you better have that money at work that day, or you've got a performance problem.” SPDRs are advantageous, he says, because they let managers get into or out of the market on a rapid basis. They also can be instantly shorted without an uptick, so they present tremendous hedging advantages. "People who wish to reduce their market exposure can go out and sell 500,000 SPDRs at $95, and they've taken $47 million–$48 million out of the market instantly,” says Bickford.

Because the instruments offer such tremendous liquidity, they are ready-made to hedge against broad equity market exposure. Of course, these kinds of moves don't come cheap, but timeliness, Bickford believes, is the most important factor. "With the kinds of moves we've had in the market,” he says, "you'd be better off taking the instantaneous action and paying incremental transaction costs then taking half an hour deciding which stocks to sell and in what quantities.”

There's another distinct advantage in using SPDRs—they're not classified as derivatives. Many investors are still wary of using the dreaded d-words, and many funds require managers to disclose the extent to which derivatives are used. SPDRs are unit trusts, and invite no such disclosure rules, so many managers feel freer in using them.

Even so, their success in the last two years has been astonishing. "The fact that the S&P has gone up 48 percent in the last year certainly hasn't hurt,” admits Bickford. But the biggest factor in the success of SPDRs this year has been momentum. Once volume starts to build, it snowballs. "One of the best advertisements in the world is trading 3 million or 4 million shares a day and finishing at or near the top of the active list,” he says.

How Volatile is the Stock Market?

By Keith Schap

‘‘August was certainly a volatile month for the U.S. equity markets or at least it felt that way,” writes Maria Tsu of Goldman Sachs in a recent research report. The whole summer, in fact, felt jumpier than a sixth grader waiting for recess. Take June 23, a day the Dow Jones Industrial Average plunged 193 points below the previous close only to soar 154 points the next day and leave many a Wall Street head shaking.

The aggregate picture seemed even more alarming. The Dow industrials have closed 1 percent or more higher or lower than the previous day's close 29.2 percent of the trading days so far this year. That contrasts with a 57-year average of only 17.2 percent.

Implied volatility on the S&P 500 Index—a more sophisticated measure—touched 24 percent in early September and traded in a range between 18 percent and 20 percent during much of 1997, a volatility far higher than the 12 percent to 16 percent range of the same period in 1996 or the 10 percent to 12 percent range of 1995.

Do the high implied volatilities indicate that traders in the option pits anticipate things will stay jumpy for a while? The answer depends on who you talk to.

Volatility of volatility

Perhaps, says Bob Bannon, managing director of Analytic-TSA Global Asset Management in Los Angeles. He agrees with the consensus that "equity market volatility has increased because of heightened fears of a potential downward correction.”

Chart A

How volatile the U.S. stock market seems depends on one's viewpoint. Chart A, showing the market to be subject to increasingly frequent wide swings from 1995 to the present, depicts an increasingly risky market. But Chart B, with implied volatility ranging between actual and intraday volatilities, suggests a more normal volatility structure, a view born out in Chart C, which uses implied volatility to show the often-mentioned 15 percent correction to be a low probability event given current market data.

Further, he says, volatility itself has become more volatile. He distinguishes between breadth of volatility, which refers to the size of a market move, and depth, which refers to the frequency of market moves. He notes that the breadth of volatility has been increasing. (See chart A below.) The telling thing about an increase on that dimension is that "having only one risk day per month is not the same as having multiple days per month with moderate to large swings.”

The chart, which is based on the percentage of daily Standard & Poor's 500 price swings in excess of 1 percent, shows that the probability of experiencing a 1 percent or greater move, in either direction, has risen to 33 percent from a 1995 low of close to 10 percent. To Bannon, that signals a queasy market because "the increase in breadth of actual volatility makes risk management a greater concern for equity portfolio managers.”

Other analysts, however, suggest the data should be taken in perspective. A look at history can help. "Although volatility has risen from its unusually low 1992–95 levels, it is not at an unprecedented high,” notes Goldman's Tsu. In fact, during the period between 1985 and 1992, the stock market appears to have been even more volatile than it is now.

Chart B

Tsu further argues that the S&P 500 and Dow Jones Industrial Average have more than doubled in the last five years, and the higher levels affect volatility perceptions. For example, it would now take an 80-point move in the Dow to achieve the same percentage swing a 28-point move caused in 1987. From this historical perspective, she concludes that volatility, though higher than it has been, remains within one standard deviation of its normal level.

Down and up

Another perspective comes from a look at the nature of volatility itself. "The whole volatility structure is going up,” says Ivan Stux, a principal at Morgan Stanley. "Implied volatility has been moving higher along with the actual market volatility rather than because of particular fears that would exhibit themselves only in the options market.”

While option users often base strategic decisions on a relationship between actual, or historical, and implied volatilities, not all analysts see the two as related. Actual volatility is the variability of price changes experienced over a specified period of data and expressed as a one-standard-deviation annualized percentage move in the index or price, while implied volatility estimates derive from the option pricing model.

Larry Langowski, a Chicago Board of Trade economist, focuses more on traders than on the pricing model. "An implied volatility,” he says, "provides a market estimate of what the mean of the daily distributions is likely to be in the future.” His research shows that to fit empirically.

"That means implied volatilities may not respond to price changes,” Langowski continues. "Rather, it deals with expectations, so the implied is likely to move when traders anticipate an event, like an interest rate change, that could be disruptive.” As a result, he's not surprised that the usual volatility charts show actual and implied volatilities to move fairly independently of each other.

Yet Stux sees an important structural relationship among the various volatilities. (See Chart B.) His chart relates implied, actual (the typical close to close difference) and intraday (the high to low sweep for the day) volatilities. "The spread between the two measures does not appear to be widening,” Stux says, referring to actual and intraday volatilities. "Because of the nature of the option pricing process, under normal circumstances the implied volatility should fluctuate between these two levels,” as the chart shows. As a result, while the whole structure has been moving higher, the implied has stayed within its natural range.

That takes the discussion back to Bannon's queasy equity managers and what all this might mean to them. The real question, though, is not whether a correction will occur but how much correction a manager can afford and how likely a move of that magnitude might be given a specified time horizon. Interestingly, volatility itself can help provide answers because, as Tsu notes, "the annual volatility figure can always be translated back into a daily or weekly volatility number.”

Given an 8,000 DJIA, a 10 percent correction would push the index down to 7,200 and 15 percent would drive it to 6,800. Table C shows the likely ranges for 30- and 60-day horizons given 20.7 percent implied volatility. There would be a 68 percent probability (one standard deviation) that the DJIA will fall somewhere between 8,474 and 7,525 30 days from now, and a 95 percent probability (two standard deviations) that it will fall somewhere between 8,949 and 7,051 during the same period.

In other words, it would take a two-standard deviation move to get to a 10 percent or 15 percent correction. While that's certainly possible, this equity market doesn't appear as stormy as it would appear at first glance.

Chart C
Standard Deviation High Low
30-day 1 8,474 7,525
2 8,949 7,051
60-day 1 8,670 7,329
2 9,341 6,659