Call it the paradox of stock trading.
As stock prices have climbed to records this year, so have trading volumes. Yet major investors complain it is more difficult than ever to trade without moving market prices, a problem that has driven up trading costs and undermined performance.
With the Dow Jones Industrial Average rocketing Friday 130.49 to 7435.78 and Standard & Poor's 500-stock index jumping 14.58 to 858.01, both records, the pressure on active fund managers to deliver similar or better results is intense. But many find they are handicapped by the difficulty of buying or selling large stock positions.
"The cost of trading is going way up, particularly for selling," says Wayne Wagner, president of Plexus Group, a trading-cost consulting firm in Santa Monica, Calif. "People are becoming trapped [in their positions], which is especially true for the Nasdaq stocks."
Many fund managers are singing a similar refrain. "It's much more difficult to find liquidity in even primary names than it was a year ago," says Michael Weiner, stock-research chief for Banc One Investment Advisors. "A year or two ago, there were hundreds of stocks we could have bought in a day or two." Now, he says, "there's only about 50."
Illiquidity, or difficulty trading without moving prices, "has been common for many years in small stocks and that has gotten worse, and in recent years we've seen that in even the most liquid stocks," says Edward Petner, president of fund manager Lynch & Mayer. Many stocks move sharply on modest volume, he says. "You're not able to buy or sell up a half or down a half; it will probably be up two or down two and, frequently, four if you have any kind of volume to move."
Such experience, though not universal, seems paradoxical given that the bull market has sent both New York Stock Exchange and Nasdaq trading volumes soaring to records. One reason for the trend, some investors say, is that brokerage firms are less willing to commit capital to customer orders.
But Wall Street trading firms argue that their capital simply has been unable to grow as quickly as the positions fund managers now trade. Nearly everyone agrees that trading costs have grown by investors' tendency to barrel en masse in and out of stocks, fueling steep price swings. All these factors have made it harder for active managers to act on their ideas, and to beat index funds, those passive portfolios that seek simply to match the performance of market indexes and boast minimal trading costs.
The most visible part of trading costscommissions-have been relatively low and stable in recent years. Bid-ask spreads, the difference between what an investor will pay for buying and receive for selling a stock, are moving lower. This is especially true in the wake of the move to trade stocks in increments of sixteenths of a dollar from eighths on all exchanges, and to decimals soon on the Big Board.
But Plexus 's Mr. Wagner says the biggest element of trading cost comes from how much a trade moves the stock price and how long an investor must wait to complete a position. And that is climbing.
Plexus measures trading cost by comparing the price of a stock when the manager decides to trade and the price at which the manager actually completes the trade. Between the fourth quarter of 1995 and the fourth quarter of 1996, Plexus found that trading costs rose for almost every stock category, and especially for small- and middle-capitalization stocks. (Small-cap stocks are those with less than $1 billion in market capitalization; mid-cap stocks have a market cap of between $1 billion and $10 billion.) For example, the cost of selling a position in a Nasdaq small-cap issue soared to 2.74% of the position from 1.98%, Plexus said.
Moreover, managers have had to slice their orders up into smaller pieces to reduce their impact, according to Plexus , which monitors 50 institutions managing more than $1 trillion in stocks.
For example, managers reduced the average trade size for mid-cap listed stocks by 9%, to 21,000 shares, and the average size of large-cap Nasdaq stocks (with over $10 billion in market cap) by 20%, to 28,000 shares, Plexus said.
Banc One's Mr. Weiner recalls a month ago taking a week to buy a modest 50,000 shares in Crane, a mid-cap industrial maker that typically trades 150,000 to 200,000 shares a day, a trade he reckons used to take a day or two. The problem wasn't lack of volume but sporadic volume, and Banc One had no chance to bid on many blocks, Mr. Weiner said.
Lynch & Mayer's Mr. Petner says despite the increased trading volumes, volatility in individual stocks has risen markedly in the past year.
"Merck started the year at around 80 and, within the first couple months, was up to about 100. It went all the way back to 80 at the end of April. That's pretty remarkable. We've had 5%-plus moves in a day in that stock, and in the old days, that happened a lot less."
Block-trading firms generally support client orders with their own capital by, for example, buying part of a sell order if insufficient buyers are present. Some fund managers say brokerage firms have become more cautious in committing capital, forcing investors to accept a bigger price impact or take longer to trade.
But Michael Clark, head of stock trading at Credit Suisse First Boston, said traders are in fact supplying more capital to customers than ever, but it hasn't matched the explosive growth in fund managers' portfolios.
"Instead of having 200,000 shares to buy, you have 2.5 million shares to buy. Once people do their homework and decide to buy, you try to provide liquidity, but it's not a given you'll find offsetting supply for that. Yes, you've identified a stock, you like its trading level; that doesn't mean you get to buy 2.5 million shares within half a point."
Indeed, many firms say stock volatility in the past year has boosted the losses they incur by committing to buy when the customer wants to sell and to sell when the customer wants to buy.
Many market participants blame stock-price volatility on investors increasingly pursuing similar strategies, triggering massive one-way trading on news events, such as a profit warning. "The news comes out, everyone tries to sell immediately, and you don't get to sell it until someone says I'll be a buyer at that price," says Mr. Wagner.
For example, when Nike released a profit warning two weeks ago, the stock plummeted to 55 3/8 from 64, with the average trade occurring at $55.36, barely above the day's low. It's usually more dramatic for small stocks. On Friday, when Storage Dimensions said it expected a shortfall in second-quarter revenue, it plunged 38%, to 6 5/16 from 10 1/4 on 13 times average volume on Nasdaq, with the average trade occurring at $6.11, close to the day's low.
-- Robert O'Brien