By: Richard Feldman
By: Richard Feldman, CFP, AIF
When dealing with investment vehicles the old adage less is more certainly rings true. High portfolio turnover in equity mutual funds can lead to dramatically less dollars in your pocket. Index funds or passively managed funds outperform actively managed funds for several reasons. The main two reasons for this out performance is that index funds typically have much lower expenses and lower portfolio turnover than most actively managed funds. Lower expense ratios play a large part in index funds out performance, but portfolio turnover may be a bigger contributing factor. Every time you buy or sell an individual stock, investors lose the spread between the bid and ask price a brokerage firm or other intermediary charges for effecting the transaction. If you read a brokerage firms earnings reports you will notice they make a lot of money trading equities. Typically it is at the expense of less sophisticated retail investors. These spreads lead to a redistribution of capital from investors to brokerage firms. In addition there are market impact charges that investors pay when large blocks of stock or illiquid small cap stocks are bought and sold. Institutional investors have begun to evaluate the impact of these costs on portfolio returns particularly in light of expectations for lower total annual portfolio returns going forward. Institutional investors have looked to technology to help lower trading costs and market impact costs by revolutionizing the way they trade stocks.
Trading equities in the past typically involved using the New York Stock Exchange for listed equities or the NASDAQ market for over the counter equities. Typically institutional pension accounts and large mutual fund companies outsourced their trading function to Wall Street brokerage firms in order to fill their buy and sell orders dictated by their analysts and portfolio managers. These institutions rarely paid attention to brokerage commissions or the impact on the market these transactions caused. In addition these institutions would often arrange deals with the brokerage firms effecting these transactions in order to receive some benefit for doing business with individual firms such as soft dollar arrangements and directed brokerage agreements. These types of arrangements typically increase trading costs for institutions because brokerage firms will typically charge more like 5 cents a share rather than 2 cents a share in these types of arrangements.
SEC Probe of NYSE
The SEC investigated and eventually settled with five specialist firms that match buyers and sellers on the floor of the New York Stock Exchange. In March of 2004 these firms settled for $240 million in fines for alleged trading misconduct.
Specialists on the floor conduct auctions among floor brokers who represent buyers and sellers of stock. But, on another hand specialists buy and sell stock for their own accounts with a major advantage since their position makes them privy to information regarding the flow of the market that other participants do not have. One fourth of all transactions on the floor of the NYSE involve specialists own capital. The system gives specialists the opportunity to engage in a practice of “front running” or giving the best deals to themselves and inferior execution to their customers. Front running can drive up the average cost of a block of stock for an institution. This could cost firms huge amounts of money since the typical institutional money management firms transacts in hundreds of thousands shares.
Liquidnet is the fastest growing alternative trading system in the history of the stock market. The system is used by 285 institutional investors buying and selling an average of 25 million shares per day as of October 2004. Liquidnet’s system lets institutional buyers and sellers anonymously move large blocks of stock when doing so has never been more difficult. Liquidnet’s average trade size is 47,540 shares which is more than ten times that of the average trade on NASDAQ or NYSE. This anonymity allows institutions to transact their buy and sell orders with little to no market impact because there is one intermediary which lessens the likelihood of other trader’s front running these institutional orders.
Money management firms have rarely looked at their trading desks as a source of investment returns. Investment management firms are starting to realize that efficiently implementing their trades through sophisticated trading operations can lead to higher investment returns. Firms are hiring traders and bringing these operations in house rather than outsource this function to the large brokerage houses that typically cost more. Firms are increasingly using alternate execution exchanges like Liquidnet, Archipelago, Instinet and Island ECN to implement their firm’s trades. These networks allow institutions to execute trades efficiently while also minimizing hard to quantify costs such as market impact. Many academics think that high portfolio turnover can cost as much as 100 to 200 basis points a year. Investment firms are beginning to use technology in order to minimize trading expense and associated market impact costs in order to increase portfolio returns.