CHAPTER 26
Cash Equities in the Secondary Market
Eric Blackman and Robert Grohskopf
INTRODUCTION
This chapter discusses the secondary cash business within an institutional equities division of a full‐service broker‐dealer such as Morgan Stanley or Deutsche Bank. The discussion will focus on how the secondary cash business is often structured, including roles and responsibilities, and how products and services are delivered to the institutional clients of the broker‐dealer. The secondary cash equity business deals with products and services related to stocks previously issued and currently trading in the marketplace. Although the secondary cash business is presented here as a standalone entity, it has connectivity with and contributes to the success of other business units within the broker‐dealer, such as investment banking, prime brokerage services, and equity derivatives.
The discussion begins with an explanation of the organizational structure of an institutional investment manager (known as the buy‐side, e.g., mutual fund, pension fund, or insurance company). The functional roles, responsibilities, and interactions among the participants, which include research analysts, portfolio managers, and buy‐side traders, will also be discussed. The next section will focus on the secondary cash business of the broker‐dealer (referred to as the sell‐side). Also discussed are the functional roles, responsibilities, and interaction of these players, which include research, research sales, sales traders, and position traders. It is essential to have a comprehensive view of both the buy‐side and sell‐side in order to fully appreciate the workings of the cash equity market business.
THE INSTITUTIONAL CLIENT
The organizational structure of most large buy‐side clients, such as mutual funds, pension funds, and insurance companies, contains the following three functional roles: portfolio manager, research analyst, and trader. The responsibilities of each of these functions, as well as the interactions among them, are discussed ahead. The reader is encouraged to refer to the Institutional Client portion of Table 26.1, and Figure 26.1, as visual references during the discussion of the institutional client.
Table 26.1: Institutional Client and Full‐Service Broker‐Dealer Roles
| Institutional Client | |||
| Function | Underlying Focus | Time Horizon | Generalist/Industry Specialist |
| Research Analyst | Fundamental Analysis | Long Term (12+ Months) | Industry Specialist |
| Portfolio Manager | Fundamental Analysis | Long Term (12+ Months) | Generalist |
| Trader | Technical Analysis | Short Term (Transactional) | Industry Specialist |
| Full Service Broker‐Dealer | |||
| Research Analyst | Fundamental Analysis | Long Term (12+ Months) | Industry Specialist |
| Research Sales | Fundamental Analysis | Long Term (12+ Months) | Generalist |
| Sales Trader | Technical Analysis | Short Term (Transactional) | Generalist |
| Trader | Technical Analysis | Short Term (Transactional) | Industry Specialist |
Figure 26.1: Internal interactions at a large institutional investor
THE PORTFOLIO MANAGER
The portfolio manager is responsible for constructing and managing the investment portfolio or fund. They determine the industry sectors in which to invest, the investment weightings of each sector, and the individual stocks to buy or sell. The fund's mandate provides overall investment guidelines that must be followed when constructing and adjusting the composition of the investment portfolio (e.g., investing in small‐cap, mid‐cap, or large‐cap issuers, or sector concentrations such as Cyclicals, Energy, or Tech). The performance of the portfolio manager is normally evaluated by comparing the fund's investment returns to the returns provided by a relevant market index, such as the S&P 500 Index or the Wilshire 5000 Index or sector benchmark such as the UTY Index for Utilities. Performance is one of the key determinants that may ultimately attract new investor capital.
The management of an investment portfolio is driven by the portfolio manager's ongoing view of the long‐term fundamental value of equities within the investment universe as a whole and its views of the relevant market sector fundamentals. The portfolio manager is often a generalist who leverages the in‐depth, fundamental valuation analysis performed by sector research analysts. Large institutional clients have teams of research analysts to support the portfolio investment process.
THE RESEARCH ANALYST
Research departments within buy‐side firms are organized according to industry sectors. Research analysts cover specific industries, such as autos, banks, or airlines, and cover individual companies within the industry (e.g., Ford, Wells Fargo, or Delta Airlines). The individual companies followed by the research analyst are referred to as the coverage universe. The research analyst develops an investment opinion of the company's stock with an expected or target stock price over either a short‐term horizon (one year or less) or a longer‐term investment horizon (typically 12 to 18 months). This investment opinion is developed through in‐depth analysis of company and industry‐related factors and trends against the backdrop of overall economic fundamentals. The analyst will examine company earnings reports, financial statements, and other company fundamentals to build a detailed financial forecasting and company valuation model. Meetings with senior management of companies under coverage are used to assess the quality of the management team and company strategy. Industry‐ and company‐specific news events are monitored closely and evaluated. Industry and company expertise from outside sources is frequently drawn upon as well.
Research analysts work closely with portfolio managers and in‐house traders communicating relevant information/analyses to further refine their models to try to enhance overall portfolio returns.
THE BUY‐SIDE TRADER
Equity trading desks at large institutional buy‐side firms are also usually organized by industry sectors. Similar to research analysts, traders become experts in the stocks within their assigned industries. However, their primary focus is transactional and short‐term in nature, in stark contrast with portfolio managers and research analysts, who have a significantly longer‐term view focusing on company and industry fundamentals and valuations. Traders are tasked with understanding the trading characteristics of their assigned companies, and, through constant interaction with the marketplace, determine how to best execute a buy and sell order. Characteristics to consider include the stock's average daily trading volume, historic price volatility, observed intraday trading patterns, current supply‐and‐demand profile, as well as trading patterns and relative price movements. When a portfolio manager decides to buy or sell a stock, a trade order is sent to the appropriate sector trader. The order identifies the stock and quantity of shares to be bought or sold and contains price instructions. It is the trader's responsibility to determine the appropriate order execution strategy, taking into account the size of the order (number of shares to be executed), the trading characteristics of the stock, and conditions within the marketplace. The trade order is then routed to a broker‐dealer for execution in the marketplace.
THE BROKER‐DEALER (SELL‐SIDE)
The secondary cash equity business of a large full‐service broker‐dealer is designed to provide value‐added equity products and services to buy‐side client. As shown in Figure 26.2, broker‐dealers are organized into functional areas responsible for delivering three main products and services: research, research sales, and trading/execution. The functional roles are research analyst, research salesperson, sales trader, and position trader. The product and service categories are research, execution, and corporate access.
Figure 26.2: Interactions between full‐service broker‐dealer and large institutional client
The secondary cash equity business is client service driven. The goal is to provide value‐added products and services, providing solutions to the institutional client while at the same time generating commission/trading revenue. Institutional clients commonly budget commission dollars for broker‐dealers based upon their determination of the value‐added to their investment objectives by a given broker‐dealer. The buy‐side research analysts, portfolio managers, and traders collectively determine the annual commission payout proportioning to a particular broker‐dealer. It is important for the broker‐dealer to coordinate sales coverage and product delivery efficiently to maximize commission revenue while ensuring quality service to the client overall. This section will discuss the following topics related to the secondary cash equity business at the broker‐dealer: functional areas and related roles and responsibilities, products and services delivered to the institutional client, the interactions of these roles with their counterparts at the institutional client, and the internal interactions among the broker‐dealer's functional areas. Please refer to Table 26.1 and Figure 26.3 as visual references during the discussion of the secondary cash equity business at a full‐service broker‐dealer.
Figure 26.3: Interactions between full‐service broker‐dealer and large institutional client
EQUITY RESEARCH
Equity research provides the buy‐side clients with insightful investment ideas and recommendations, supported by a detailed analysis related to the economy, financial markets, industry sectors, and individual companies within these sectors. Equity research departments at large full‐service broker‐dealers typically employ economists, equity strategists, and company research analysts to this end. These departments produce reports and studies on the U.S. and global economies, financial markets, portfolio strategies, topical thematic investment considerations, industry sectors, and individual companies.
Analysts covering individual companies produce the majority of research reports and thus account for a large portion of the research budgets at full‐service broker‐dealers.
THE RESEARCH ANALYST
Sell‐side research analysts utilize fundamental analysis to evaluate companies in their coverage universe, estimating the potential value of the company and determining an expected per‐share stock price (the target price). They examine the company's financial statements, the overall market for the firm's products or services, its competition, industry‐ and company‐specific risks, as well as macroeconomic and regulatory considerations. These data points serve as inputs into a detailed financial model to assist in the valuation of companies covered by the analyst.
Research analysts develop and maintain professional relationships with senior management at the companies in their coverage universe to augment the analyses described earlier. When valuing a company, it is imperative for the research analyst to clearly understand senior management's strategy and assess the probability of successful implementation and the potential impact of that strategy. Development of these strong relationships goes a long way to that end and serves as a key ingredient to a successful corporate action program as discussed later in this chapter.
Research analysts publish industry‐ and company‐specific research reports for distribution both internally and externally to the firm's institutional clients. These reports typically address a specific topic, such as the impact of an important announcement by or about the company or an analysis of the company's quarterly earnings release. The research report will normally include the analyst's 12‐month price target for the stock, the analyst's investment opinion (buy, sell, or hold), data on important stock valuation metrics, and the analyst's detailed financial and valuation models and ratings rationale.
Internally, the research analyst interfaces with both the research sales and trading teams. While they work more closely with research salespeople, who are responsible for selling the firm's research product, a meaningful dialogue and exchange of ideas and information also takes place with the firm's trading desk in accordance with compliance requirements.
RESEARCH SALES
The traditional role of a research salesperson is to sell the firm's research product to its institutional client base. Research sales is organized by client accounts with each salesperson responsible for between 15 and 25 institutional clients (known as their “account package”). A research salesperson acts as the channel connecting the firm's research to the appropriate consumer at the institutional client and thus must have a general understanding of all the firm's product offerings across all sectors.
The research salesperson must also have an understanding of the investment processes used by each portfolio manager as well as their investment needs, with the ultimate goal of providing a high‐value research offering that ultimately the client will pay for in the form of trading commissions.
Another important product offered by the research sales team is corporate access. Through corporate access, portfolio managers and buy‐side research analysts may be introduced to members of senior management of companies in which they invest or may potentially invest. It is important that the research sales team works hand‐in‐hand with its internal research analysts to coordinate the delivery of the analysts' industry and company expertise to the institutional client. The research sales team also works closely with the sales traders responsible for executing trades on behalf of their clients.
EXECUTION
Execution is the completion of a buy or sell order for an equity security. (Broker‐dealers provide institutional clients with their trading expertise related to specific markets, industries, and individual stocks as well as access to sources of market liquidity in order to optimize trade execution. Broker‐dealers seek to uncover sources of liquidity, provide best execution, and not cause significant adverse price movements. In the United States, there are 11 stock exchanges and over 40 alternative trading systems (ATSs). An ATS is an SEC regulatory term for a non‐exchange‐trading venue. In addition, liquidity to facilitate the execution of client orders can be provided internally at broker‐dealers by matching client orders (known as natural order flow) or by committing firm capital and playing the role of principal intermediary.
Trading in the United States has continued to become increasingly automated, fast‐paced, and further fragmented among the numerous trading venues. In order to access these pools of liquidity with the necessary speed and efficiency, electronic trading platforms and electronic trading tools are utilized. Broker‐dealers typically spend considerable time and resources developing and upgrading these platforms and tools in order to provide the most efficient trading services it can offer.
Electronic trading tools generally use three components: execution algorithms (algos), smart order routers (SOR), and direct market access (DMA). Algos are complex mathematical formulas that determine and execute trading strategies to fit a particular market order, such as a volume‐weighted average price (VWAP) model, which would be written to automatically buy or sell a given stock over the trading day to achieve VWAP for that day. Algos determine the manner and timing of a trading strategy, the how‐and‐when‐to‐trade decisions. SORs determine where the best sources of liquidity to access are in order to direct automated trading systems to that venue; for example, a given stock may find more liquidity in the FINRA ADF versus the NYSE. DMA provides the electronic connectivity directly to sources of liquidity, such as exchanges and ATSs.
Many full‐service broker‐dealers provide their institutional clients with three execution channels: high touch, program trading, and electronic. Clients can choose to use the channel that is best suited for a given buy/sell order or group of orders. High‐touch execution will be the example used to highlight the execution product. High‐touch trading best illustrates the interaction between buy‐side traders and their broker‐dealer counterparts and generally accounts for the largest portion of secondary cash commissions paid by institutional clients.
High‐touch execution has two functions: sales trading and position trading.
Sales Trading
Sales traders are the primary execution point of contact for the institutional client. Sales trading is organized by client account groupings, with each sales trader usually responsible for between 15 and 25 clients (the account coverage package). Developing, maintaining, and managing close client relationships based on competency and mutual trust is an important responsibility of the sales trader. High‐touch execution is a relationship‐driven business. This is especially true when a buy‐side trader is deciding which broker‐dealer to use for execution of a difficult or complex trade order or when the broker‐dealer will be asked to use firm capital to facilitate trade execution. Sales traders are generalists, providing value‐added content and order execution services across all industries to their clients' trading desks. Although sales traders provide high‐level research product summaries to buy‐side traders, the content delivered daily to their clients focuses more on technical aspects of the market, industry sectors, and the trading characteristics or behavior of individual stocks. Sales traders are in frequent contact with their clients' traders throughout the day, either electronically or by telephone. Contact during the trading day usually centers on important developments in the market or in individual stocks, updates on live trade orders, or developments in sources of liquidity that might be of interest (e.g., a new sell order from another client the buy‐side trader might wish to purchase).
Order execution is the important responsibility of the sales trader. This activity is transactional in nature, as sales traders execute their client orders in the marketplace. Sales traders can also act as the intermediary between the position traders and the buy‐side trader. This can occur, for example, when the position trader is committing capital to facilitate (or enable) a trade. Here, based on the client's objectives, the sales trader may help negotiate the terms of the order.
Position Trading
Position traders specialize in industry sectors such as autos, banks, and airlines, and are responsible for the following activities: commitment of firm capital, position risk management, and execution. Position traders have an expertise in understanding the trading characteristics and price patterns of specific stocks in their industry sectors. Their activities are generally short‐term and transactional in nature, focusing on timely and accurate trade execution.
Position traders should have well‐developed relationships with their buy‐side trading counterparts and strive to be a trusted source of expertise in the stocks they trade. Position traders communicate frequently and directly with buy‐side traders (either electronically or by phone), providing industry‐ and company‐specific content such as important news or events, expected stock price impact, observed trends, and the trading supply‐and‐demand profile for their covered stocks.
Order execution is the important activity performed by the position trader. In some cases, the position trader may take over execution of an order the sales trader may be having difficulty with. In another case, where the trader has other clients wishing to buy or sell the same stock, he or she will attempt to bring all the parties together, thus organizing and executing a large crossing trade at a mutually acceptable price. The position trader can thus interface and negotiate directly with the buyers and sellers or work through the sales traders. The role of the position trader is vital to providing additional liquidity available for its clients. They frequently act as an intermediary to match actual or prospective buyers and sellers in the stocks they trade.
The commitment of firm capital in trade execution and risk management of open stock positions are two activities that are performed exclusively by position traders. Position traders commit firm capital for their institutional clients as the buyer or seller of last resort in order to enable (or facilitate) the execution of a trade. This is one particular activity that is highly valued by institutional clients and may occur, for example, when a client needs to buy a stock that is not readily available for sale in the marketplace or through other clients of the broker‐dealer. The position trader can step in as the seller, providing liquidity otherwise unavailable in the market by selling the stock short. Price and trade quantity are negotiated with the buy‐side trader and are based on many factors, such as trading volumes, current short interest, current market conditions, anticipated price movement of the stock, and other client‐related considerations. The trade is then negotiated with the buy‐side trader and can occur directly with the position trader or through the sales trader assigned to the account. For the position trader, this transaction results in a short position in the stock. If the client had been a seller of the stock in this example, the capital commitment would have been a long position for the position trader.
The position trader is also responsible for managing any potential position risk that may result in a loss due to adverse price movements associated with positions created through capital commitment activities. Capital commitment involves negative selection on the part of the position trader, meaning the client selects the stock, quantity, and timing of the trade, and the position trader responds by providing liquidity when other buyers or sellers are not available. The position trader will manage the risk associated with the position with an offsetting trade of the stock in the marketplace or directly with clients. They also may hedge the risk by buying and selling other instruments such as futures, options, or swaps.
ADDITIONAL PRODUCTS AND SERVICES
The following products have been referenced within the previous sections: corporate access and execution channels for program trading and electronic trading. Each of these is discussed in the following.
Corporate Access
Corporate access makes senior management of a client company available to the broker's institutional client base (usually portfolio managers, research analysts, and senior management). Institutional investors want to meet with senior management to better understand the company's strategic vision, and to evaluate the quality of the senior management team as well as to discuss specific company‐ and industry‐related issues. On the other side of the coin, senior executives of the client company may want to meet with current and prospective investors in order to strengthen and broaden the investor base of the company. Corporate access represents a significant portion of the commission wallet for institutional clients and is an important product offering of a large broker‐dealer's secondary cash business.
Various functional roles within the broker‐dealer may work together to execute this match‐making service such as research analysts as well as investment bankers to leverage their relationships at the companies they cover to obtain senior management participation in these events. Research salespeople utilize their institutional client relationships to identify and arrange participation from the appropriate portfolio managers and buy‐side research analysts. A marketing coordinator will usually work with the groups to coordinate the corporate access event.
There are four types of corporate access events: non‐deal roadshows (NDRs), investor conferences, investor field trips, and the bespoke event. In an NDR, company management typically travels to various geographic regions and meets one‐on‐one with institutional clients at the client's offices. Each one‐on‐one meeting typically lasts 60 minutes, and numerous client meetings are held over the course of the NDR. The one‐on‐one meetings tend to be highly valued by portfolio managers and research analysts as it gives them singular access to corporate management. Likewise, corporate management teams can get valuable feedback from their institutional investor base.
Conferences are arranged at a single location for the senior management teams of companies within an industry to interact with many institutional clients. Conferences will usually have industry panel discussions, individual company presentations, and one‐on‐one meetings usually lasting 35 minutes. The sell‐side research analyst covering the industry is actively involved in these conferences, interfacing between company management and institutional clients. Sell‐side research analysts will typically write up and publish notes on the conference for distribution both internally and to the institutional client base.
Investor field trips provide a venue for a group of institutional clients to meet with senior management at the company's facilities. Investor field trips are usually industry specific.
Bespoke events are arranged at the request of a single institutional client. It provides portfolio managers and buy‐side research analysts with access to senior management of a specific company. The client usually travels to the company's headquarters for the meeting and gives the client an opportunity to kick the tires.
Execution Channels: Program Trading and Electronic Trading
Full‐service broker‐dealers provide two additional trade execution channels: program trading and electronic trading. In program trading, individual orders are grouped into a portfolio of orders for execution by the broker‐dealer. An example of this is when a client has a meaningful adjustment to or rebalancing of the composition of an investment portfolio that will potentially result in a basket of buy and sell orders across many individual stocks. The basket of orders, referred to as a program, may be executed in the marketplace by the broker‐dealer on behalf of the institutional client and is known as an agency program. Alternatively the buy‐side trader may request that the broker‐dealer commit firm capital and become the counterparty to each of the individual transactions. This is known as a principal program. With a principal program, the trader must manage the risk associated with the resulting long or short stock positions as mentioned earlier.
The electronic trading channel enables buy‐side traders to execute their orders directly in the marketplace utilizing electronic platforms and tools provided by the broker‐dealer. Orders executed through the electronic trading channel completely bypass both the sales and position traders, and firm capital is not committed. Commission rates for orders executed in the electronic trading channel are typically in the range of $0.002 to $0.004 per share as compared to a range of $0.02 to $0.04 per share for orders executed in the high‐touch channel. However, the aggregate potential quantity of shares executed through the electronic trading channel is many multiples of the quantity executed through the high‐touch channel.
CONCLUSION
It is important to note that the structure, roles, responsibilities, and products of a secondary cash equities business as detailed in this chapter can vary across different financial institutions. It is also worth noting that recent regulatory scrutiny on the cash equities business (e.g., electronic trading, dark pools, and high‐frequency trading) will have both short‐ and long‐term impacts on the functioning of these businesses. For example, in 2015 the SEC enacted the Systems Compliance and Integrity Rule (Reg. SCI). This rule requires some broker‐dealers who use electronic trading platforms (alternative trading systems (ATSs) or dark pools) to adhere to a much stricter set of requirements with the goal of reducing systemic risk. As a result, some electronic trading groups have implemented new controls that actually stop execution through these platforms just prior to the established rule trigger to avoid the stricter requirements. In an industry that has historically focused on maximizing order flow to increase revenues, rejecting order flow for regulatory risk management purposes demonstrated the need for firms to monitor and perhaps revise their operating models to respond to the changing regulatory landscape. The ever‐changing regulatory environment, combined with disruptive financial technologies such as Blockchain and cryptocurrency (FinTech), will play a significant role in the evolution of the equity markets in the future and their place in the capital markets ecosystem.