them back at a lower price.^3 This proves to be a very convenient way of
hedging portfolio gains if an investor fears the market may fall. And fi-
nally, ETFs are extremely tax efficient since, unlike mutual funds, they
generate almost no capital gains either from the sales of other investors or
from portfolio changes to the index. This is because swaps between the
ETFs and underlying shares are considered exchanges in kindand are not
taxable events. Later in this chapter we will list the advantages and dis-
advantages of ETFs as compared to alternative forms of index investing.STOCK INDEX FUTURES
ETFs are really the outgrowth of one of the most important trading in-
novations of the last 50 years—the development of stock index futures in
the early 1980s. Despite the enormous popularity of these new ex-
change-traded funds, the total dollar volume in ETFs is still dwarfed by
the dollar volume represented by trading in index futures, most of
which began trading in Chicago but are mostly now traded on electronic
exchanges. Shifts in overall market sentiment often impact the index fu-
tures market first and then are transmitted to stocks traded in New York.
To understand how important index futures were to stock prices in
the 1980s and 1990s, one need only look at what happened on April 13,- It began as an ordinary trading day, but at about 11:45 in the morn-
ing, the two big Chicago futures exchanges, the Board of Trade and the
Mercantile Exchange, were closed when a massive leak from the
Chicago River coursed through the tunnels under the financial district
and triggered extensive power outages. The intraday movement of the
Dow Industrials and the S&P futures is shown in Figure 15-1. As soon as
the Chicago futures trading was halted, the volatility of the stock market
declined significantly.
It almost looks as if the New York Stock Exchange went “brain
dead” when there was no lead from Chicago. The volume in New York
dropped by more than 25 percent on the day the Chicago futures market
was closed; and some dealers claimed that if the futures exchange re-
mained inoperative, it would cause liquidity problems and difficulty in
executing some trades in New York.^4 Michael Metz, a market strategist
at Oppenheimer & Co., declared: “It’s been absolutely delightful; it
CHAPTER 15 The Rise of Exchange-Traded Funds, Stock Index Futures, and Options 253
(^3) ETFs are exempt from the uptick rule that until recently restricted shorting stock when the price is
falling.
(^4) Robert Steiner, “Industrials Gain 14.53 in Trading Muted by Futures Halt in Chicago,” Wall Street
Journal, April 14, 1992, p. C2.