November 3, 2009

Size (of trades) Matters

Mother Nature and Denver last week were like a samba episode of Dancing with the Stars, twirling furiously. In fact, snow torpedoed my trip to Boston, but only after an hour floundering through a foot of slush to the airport at an average speed of 25 mph. And today it’s 70 degrees on the Front Range.

Switching gears, I owe a mea culpa. We’ve berated the exchanges for fueling conditions that constrain real investment – fragmentation, rebates, direct access, sponsored access, high-frequency trading, flash orders etc, et al, since data and transactions are keys to exchange prosperity. But Duncan Niederauer’s interview in the weekend Wall Street Journal (see link below) was the best call yet for return to capital formation in the equity markets. I am now cooking up a comfort-food casserole of crow in the crock pot.  I did drop a note to Mr. Niederauer saying so, too.

A word on the markets and then let’s talk about the size of trades and why they matter to your IR efforts.  These renewed swings of a percent or more lately on major measures reflect forms of statistical arbitrage in which systems tweak assets and seek small gains, while all around the noise plays. We do not see anywhere that more than 10% of volume reflects conventional value investing.

Which leads us to trade size. SEC, we hope you hear this. Issues of all sizes and shapes reflect nearly the same number of shares per trade.  Say your stock trades 2,000 times per day and your volume is 375,000 shares.  You average about 190 shares per trade. If you trade 5 million shares a day and 27,000 times daily, your average trade size is…about 190 shares.

What’s wrong with that?  We’re coming to it.  Trade sizes are a consequence of best execution rules, which require brokers to work within standard deviation. In time, there’s little deviation, or you get fined. We’ve defined a single entry standard for a vastly disparate market of 10,000 different companies.

What happens? The moment an institutional algorithm begins to make trades that consume liquidity – or “take” it – someone else’s algorithm looking for rebates leaps in between.  Thus we have markets where everyone must make and take liquidity, which becomes in time an end unto itself. Seldom – about one out of ten times – are active participants able to do more than tweak positions.

Plus, costs for doing so are low.  Advocates of this system trumpet low costs as though that’s the Holy Grail. The Holy Grail is a fat pipe of IPOs. Seen that lately?

In fact, the cost of capital formation is extremely high.  If you trade 2,000 times per day at 190 shares per trade, any value institution will be front-run before it ever gets close to 200 trades, or 10% of your daily volume. How will this value investor own your stock?

Likely, in baskets or ETFs.  It’s hard for an institution to buy or sell your stock as an end unto itself, unless it’s a hedge fund.

Now wait, there’s good news too. We’re here to make you look cool in the IR chair, after all.

If before, institutions needed 100,000 shares to realize gains, now they need only 10,000.  How? Suppose your prospective institutional investor buys 10,000 shares on a given day, and you trade 2,000 times per day. You may be nearly assured of appreciation in the coming 2-3 days, because the activity ripples through your market structure, changing the math and the behavior.

So, message accordingly!  Remind institutions that smaller commitments may produce appreciation – the desired outcome. Capital appreciation can be had for less money, so to speak. Hey, it’s an imperfect solution to a perplexing problem of rules – but we’re trying!

How will you measure these effects?  Market structure.  Learn it, love it, live it, IROs.  Rules aren’t going to change soon.  That’ll take time, and let’s all keep fighting that good fight.

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