December 11, 2013

Retail Reality

Do retail investors matter?

Depends what you mean. They’re important and valuable as investors. I once headed investor relations for a company with thousands of retail holders. I was president of an IR services firm that focused on retail-targeting strategies.

But when people ask me if retail investors have a chance in the market, my answer is monosyllabic: No. Scottrade, the online brokerage, runs ads featuring clients claiming that “I don’t trade like everyone else. I trade like me.” That seems to suggest retail traders can craft unique schemes that stand apart. While it’s theoretically conceivable for a retail order to price the market under rules requiring “market” orders to meet at the best national offer to sell, in practice it’s remote. Retail orders are passengers on market trains.

I’ll explain. Scottrade says in its order-routing filings that 100% of its trades are non-directed – they don’t specify execution venues. The average Scottrade customer is thus statistically most likely to trade not like you or me or him or her, but like Knight Securities, since that’s where a quarter of Scottrade orders go.

Another chunk from Scottrade lands at Citadel, the high-speed hedge-fund owned platform. Citigroup gets the largest portion but it’s divided between limit orders at Lavaflow, Citi’s fast-trading facility, and market orders at Citigroup’s agency desk (suggesting Citi powers arbitrage).

About 15% of orders shoot through Direct Edge, the high-frequency-trading exchange that’s merging with BATS, another sizzling execution venue. And for options and futures and NYSE stocks, about 7% of Scottrade’s orders route to G1 Securities that until recently was owned by rival E*Trade, which has sold it Susquehanna, a quantitative trader. Yup, folks who hoped to “trade like me” were actually trading like E*Trade.

I’m not picking on Scottrade. All the online firms do this. You’re perhaps most likely to trade as you intend at Schwab – but Schwab sends 95% of its orders to UBS, and the rest mainly to Citadel, Knight and Direct Edge just like Scottrade. E*Trade does too – same firms, except that it’s promised to send 70% of orders to Susquehanna for five years.

What’s going on with all this order flow? High-frequency trading. You can call it “retail,” but that’s not a good definition. Retail folks enter orders, and their online brokerage loads them onto various “trains” that carry traffic into “stations” consisting of exchanges and other brokers, who pay for the traffic. Fees paid for these orders range from about $0.15 per hundred traded shares to over $0.30 a hundred at Direct Edge.

To say the characteristics determining their pricing possess investment features is true only to the extent that they originated with some individual investors at some point along the way. But in market terms, that was eons, ages ago, and the orders have become fodder for intermediaries filling all manner of other orders. Even in the most heavily retail stocks we track, it’s rare to see a retail trade-execution venue in the top ten or with more than 0.5% of overall trade-executions. In fact, the only retail brokerage, data suggest to us, that has a prayer of pricing individual stocks is Interactive Brokers.

Frankly, this is true for lots of institutional money too. If it’s trying to buy a steady portion of your stock, it will behave according to the direction of, say, algorithms at Credit Suisse, which may in turn be geared to the needs of an ETF family.

Why? Rules subordinate investment objectives to trade-execution standards. Uniformity reigns. The means trumps the ends. Your investors can’t just march into the market and buy your stuff as if they were going to the grocery store.

Oh, you think that would be better? I agree! Making that happen will require a lot more activism from public companies. Until then, everybody trades the way the algorithms and the regulators say. Got it? Good.

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