Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Frank J. Jones, Ph.D.

Chief Investment Officer The Guardian Life Insurance Company of America

Robert R. Johnson, Ph.D., CFA

Senior Vice President Association for Investment Management and Research

In this chapter we will discuss the investment characteristics of common stock, explain the markets where common stock is traded, the arrangements made for the trading of common stock by retail (i.e., individual) and institutional investors, and review common stock portfolio strategies.

COMMON STOCK VERSUS PREFERRED STOCK

Common stocks are also called equity securities. Equity securities represent an ownership interest in a corporation. Holders of equity securities are entitled to the earnings of the corporation when those earnings are distributed in the form of dividends ; they are also entitled to a pro rata share of the remaining equity in case of liquidation.

Common stock is only one type of equity security. Another type is preferred stock. The key distinction between the two forms of equity securities is the degree to which their holders may participate in any distribution of earnings and capital and the priority given to each class in the distribution of earnings. Typically, preferred stockholders are entitled to a fixed dividend, which they receive before common stockholders may receive any dividends. Therefore, we refer to preferred stock as a senior corporate security, in the sense that preferred stock interests are senior to the interests of common stockholders. Preferred stock is discussed Chapter 12.

WHERE STOCK TRADING OCCURS

It is in the market for common stock through the trades they make that investors express their opinions about the economic prospects of a company. The aggregate of these trades provides the market consensus opinion about the price of the stock.

In the United States, secondary market trading in common stocks has occurred in two different ways. The first is on organized exchanges, which are specific geographical locations called trading floors, where representatives of buyers and sellers physically meet. The trading mechanism on exchanges is the auction system, which results from the presence of many competing buyers and sellers assembled in one place.

The second type is via over-the-counter (OTC) trading, which results from geographically dispersed traders or market-makers linked to one another via telecommunication systems. That is, there is no trading floor. This trading mechanism is a negotiated system whereby individual buyers negotiate with individual sellers.

Exchange markets are called central auction specialist systems and OTC markets are called multiple market maker systems. In recent years a new method of trading common stocks via independently owned and operated electronic communications networks (ECNs) has developed and is growing quickly.

In the United States there are two national stock exchanges: (1) the New York Stock Exchange (NYSE), commonly called the “Big Board,” and (2) the American Stock Exchange (AMEX or ASE), also called the “Curb.” National stock exchanges trade stocks of not only U.S. corporations but also non-U.S. corporations. In addition to the national exchanges, there are regional stock exchanges in Boston, Chicago (called the Midwest Exchange), Cincinnati, San Francisco (called the Pacific Coast Exchange) and Philadelphia. Regional exchanges primarily trade stocks from corporations based within their region.

The major OTC market in the U.S. is NASDAQ (the National Association of Securities Dealers Automated Quotation System), which is owned and operated by the NASD (the National Association of Securities Dealers), although it is in the process of becoming independent. The NASD is a securities industry self-regulatory organization (SRO) that operates subject to the oversight of the Securities and Exchange Commission (SEC). NASDAQ is a national market. During 1998, NASDAQ and AMEX merged to form the NASDAQ-AMEX Market Group, Inc.

The NYSE is the largest exchange in the U.S. with the shares of approximately 3,000 companies listed. The AMEX is the second largest national stock exchange in the U.S., with over 750 issues listed for trading. NASDAQ has a greater number of listed stocks but with much less market capitalization than the NYSE.

According to the Securities Act of 1934, there are two categories of traded stocks. The first is exchange traded stocks (also called “listed” stocks). The second is OTC stocks which are also non-exchange traded stocks and are, thus, by inference, “non-listed.” However, as we will describe later in this chapter, NASDAQ stocks have listing requirements (the NASDAQ National Market and the NASDAQ Small Capitalization Market). Thus, a more useful and practical categorization is as follows:

1. Exchange listed stocks (national and regional exchanges)
2. NASDAQ listed OTC stocks
3. Non-NASDAQ OTC stocks

We will focus on each of these markets later in this section.

The four major types of markets on which stocks are traded are referred to as follows:

• First Market—trading on exchanges of stocks listed on an exchange
• Second Market—trading in the OTC market of stocks not listed on an exchange
• Third Market—trading in the OTC market of stocks listed on an exchange
• Fourth Market—private transactions between institutional investors who deal directly with each other without utilizing the services of a broker-dealer intermediary

These types of markets are discussed in the following sections.

Exchanges

Stock exchanges are formal organizations, approved and regulated by the SEC. They are comprised of “members” that use the exchange facilities and systems to exchange or trade “listed” stocks. These exchanges are physical locations where members assemble to trade. Stocks that are traded on an exchange are said to be listed stocks. That is, these stocks are individually approved for trading on the exchange by the exchange. To be listed, a company must apply and satisfy requirements established by the exchange for minimum capitalization, shareholder equity, average closing share price, and other criteria. Even after being listed, exchanges may delist a company’s stock if it no longer meets the exchange requirements.

To have the right to trade securities or make markets on an exchange floor, firms or individuals must become a member of the exchange, which is accomplished by buying a seat on the exchange. The number of seats is fixed by the exchange and the cost of a seat is determined by supply and demand by those who want to sell or buy seats.

There are two kinds of stocks listed on the five regional stock exchanges:

1. Stocks of companies that either could not qualify for listing on one of the major national exchanges or could qualify for listing but chose not to list
2. Stocks that are also listed on one of the major national exchanges

The second group of stocks are called dually listed stocks. The motivation of a company for dual listing is that a local brokerage firm that purchases a membership on a regional exchange can trade their listed stocks without having to purchase a considerably more expensive membership on the national stock exchange where the stock is also listed. Alternatively, a local brokerage firm could use the services of a member of a major national stock exchange to execute an order, but in this case it would have to give up part of its commission.

The regional stock exchanges compete with the NYSE for the execution of smaller trades. Major national brokerage firms have in recent years routed such orders to regional exchanges because of the lower cost they charge for executing orders or the better prices received.

The NYSE

The NYSE is conducted as a centralized continuous auction market at a designated location on the trading floor, called a “post,” with brokers representing their customers’ buy and sell orders. A single specialist is the market maker for each stock. A member firm may be designated as a specialist for the common stock of more than one company, that is, several stocks can trade at the same post. But only one specialist is designated for the common stock of each listed company.

A specialist for each stock stands at a trading position around one of the 17 NYSE “posts.” Each post is essentially an auction site where orders, bids, and offers arrive. Most orders arrive from floor brokers via an electronic delivery system called the SuperDot (Super Designated Order Turnaround). SuperDot is an electronic order routing and reporting system linking member firms electronically worldwide directly to the specialist’s post on the trading floor of the NYSE. The majority of NYSE orders are processed electronically through SuperDot.

In addition to the single specialist market-maker on an exchange, other firms that are members of an exchange can trade for themselves or on behalf of their customers. NYSE member firms, which are broker-dealer organizations that serve the investing public, are represented on the trading floor by brokers who serve as fiduciaries in the execution of customer orders.

The largest membership category on the NYSE is that of the commission broker. A commission broker is an employee of one of the nearly 500 securities houses (“stockbrokers” or “wirehouses”) devoted to handling business on the exchange. Commission brokers execute orders for their firm on behalf of their customers at agreed commission rates. These houses may deal for their own account as well as on behalf of their clients.

Other transactors on the exchange floor include the following categories. Independent floor brokers work on the exchange floor and execute orders for other exchange members who have more orders than they can handle alone or who require assistance in carrying out large orders. Floor brokers take a share in the commission received by the firm they are assisting. Registered traders are individual members who buy and sell for their own account. Alternatively, they may be trustees who maintain membership for the convenience of dealing and to save fees.

As explained earlier, specialists are dealers or market makers assigned by the NYSE to conduct the auction process and to maintain an orderly market in one or more designated stocks. Specialists may act as both a broker (agent) and a dealer (principal). In their role as a broker or agent, specialists represent customer orders in their assigned stocks, which arrive at their post electronically or are entrusted to them by a floor broker to be executed if and when a stock reaches a price specified by a customer (limit or stop order). As a dealer or principal, specialists buy and sell shares in their assigned stocks for their own account as necessary to maintain an orderly market. Specialists must always give precedence to public orders over trading for their own account.

In general, public orders for stocks traded on the NYSE, if they are not sent to the specialist’s post via SuperDot, are sent from the member firm’s office to its representative on the exchange floor, who attempts to execute the order in the trading crowd. Later in this chapter we discuss the various types of orders that an investor can ask a broker to execute. There are certain types of orders where the order will not be executed immediately on the trading floors. These are limit orders and stop orders. If the order is a limit order or a stop order and the member firm’s floor broker cannot transact the order immediately, they can wait in the trading crowd or give the order to the specialist in the stock, who will enter the order in that specialist’s limit order book (or simply, book) for later execution based on the relationship between the market price and the price specified in the limit or stop order. The book is the list in which specialists keep the limit and stop orders given to them, arranged by size, from near the current market price to further away from it. While the book was formerly an actual physical paper book, it is now maintained electronically. Only the specialist can view the orders in the book for their stock. This exclusivity with respect to the limit order book is obviously an advantage to the specialist, which to some degree offsets their obligation to make fair and orderly markets. At the time of this writing, however, the NYSE was planning to make the specialists’ book available to investors electronically.

A significant advantage of the NYSE market is its diversity of participants. At the exchange, public orders meet each other often with minimal dealer intervention, contributing to an efficient mechanism for achieving fair securities prices. The liquidity provided by the NYSE market stems from the active involvement of the following principal groups: the individual investor; the institutional investor; the member firm acting as both agent and dealer; the member-firm broker on the trading floor acting as agent, representing the firm’s customer orders; the independent broker on the trading floor acting as agent and handling customer orders on behalf of other member firms; and the specialist, with assigned responsibility in individual securities on the trading floor. Together these groups provide depth and diversity to the market.

NYSE-assigned specialists have four major roles:

1. As dealers, they trade for their own accounts when there is a temporary absence of public buyers or sellers, and only after the public orders in their possession have been satisfied at a specified price.
2. As agents, they execute market orders entrusted to them by brokers, as well as orders awaiting a specific market price.
3. As catalysts, they help to bring buyers and sellers together.
4. As auctioneers, they quote current bid/asked prices that reflect total supply and demand for each of the stocks assigned to them.

In carrying out their duties, specialists may, as indicated, act as either an agent or a principal. When acting as an agent, the specialist simply fills customer market orders, limit or stop orders (either new orders or orders from their book) by opposite orders (buy or sell). When acting as a principal, the specialist is charged with the responsibility of maintaining a fair and orderly market. Specialists are prohibited from engaging in transactions in securities in which they are registered unless such transactions are necessary to maintain a fair and orderly market. Specialists profit only from those trades in which they are involved; that is, they realize no revenue for trades in which they are an agent.

The term “fair and orderly market” means a market in which there is price continuity and reasonable depth. Thus, specialists are required to maintain a reasonable spread between bids and offers and small changes in price between transactions. Specialists are expected to bid and offer for their own account if necessary to promote such a fair and orderly market. They cannot put their own interests ahead of public orders and are obliged to trade on their own accounts against the market trend to help maintain liquidity and continuity as the price of a stock goes up or down. They may purchase stock for their investment account only if such purchases are necessary to create a fair and orderly market.

Specialists are responsible for balancing buy and sell orders at the opening of the trading day in order to arrange an equitable opening price for the stock. Specialists are expected to participate in the opening of the market only to the extent necessary to balance supply and demand for the security to effect a reasonable opening price. While trading throughout the day is via a continuous auction-based system, the opening is conducted via a single-price call auction system. The specialists conduct the call and determine the single price.

If there is an imbalance between buy and sell orders either at the opening or during the trading day and the specialist cannot maintain a fair and orderly market, then they may, under restricted conditions, close the market in that stock (that is, discontinue trading) until they are able to determine a price at which there is a balance of buy and sell orders. Such closes of trading can occur either during the trading day or at the opening, which is more common, and can last for minutes or days. Closings of a day or more may occur when, for example, there is an acquisition of one firm by another or when there is an extreme announcement by the corporation (for this reason, many announcements are after the close of trading).

The Over-the-Counter Market

The OTC market is called the market for “unlisted stocks.” As explained earlier, while there are listing requirements for exchanges, there are also “listing requirements” for the NASDAQ National and Small Capitalization OTC markets, which are discussed in the following section. Nevertheless, exchange traded stocks are called “listed,” and stocks traded on the OTC markets are called “unlisted.”

There are three parts of the OTC market—two under the aegis of NASD (the NASDAQ markets) and a third market for truly unlisted stocks, the non-NASDAQ OTC markets.

NASDAQ Stock Market

Established in 1971, the NASDAQ stock market was developed as a wholly-owned subsidiary of the NASD. The NASD is the National Association of Securities Dealers, a self-regulatory organization (SRO) subject to oversight by the SEC. NASD, a private organization, represents and regulates the dealers in the OTC market.

NASDAQ is essentially a telecommunications network that links thousands of geographically-dispersed market making participants. NASDAQ is an electronic quotation system that provides price quotations to market participants on NASDAQ listed stocks. While there is no central trading floor, NASDAQ has become an electronic “virtual trading floor.” There are more than 4,700 common stocks included in the NASDAQ system with a total market value of over $3.5 trillion. Some 535 dealers, known as market makers, representing some of the world’s largest securities firms, provide competing bids to buy and offers to sell NASDAQ stocks to investors.

The NASDAQ stock market has two broad tiers of securities: (1) the NASDAQ National Market (NNM) and the Small Capitalization Market. Newspapers have separate sections for these two tiers of stocks (sections labeled the “NASDAQ National Market” and the “NASDAQ Small Capitalization Market”). The NASDAQ NMS is the dominant OTC market in the United States.

As of December 2000, there were approximately 3,800 stocks on the NASDAQ NNM system and 900 on the Small Cap Market. The Small Cap Market is smaller in terms of number of companies, trading volume (both share and dollar amount), and market value of companies

Securities are actually “listed” on both tiers of NASDAQ, that is they must meet fairly stringent listing requirements for size, issuer profitability, trading volume, governance, public disclosure, and other factors. Securities traded on these NASDAQ tiers must meet specified minimum standards for both initial listing and continued listing. The financial criteria for listing in the Small Cap Market are not as stringent as in the NNM system. Small Cap companies often grow and move up to the NNM market. The NNM issues are more widely known, have more trading volume, and have more market makers.

There are also differences in the listing requirements for the NYSE and NASDAQ (NNM). One difference is that profitability is required for companies listed on NYSE but not on NASDAQ. The requirement for market capitalization also differs.

Many stocks that qualify for listing on the NYSE remain on NASDAQ, including Microsoft and Intel at the end of 2000. Occasionally companies switch from NASDAQ to the NYSE. However, only one has switched from the NYSE to NASDAQ since 1970 (Aeroflex, Inc.).

The main responsibility of a NASDAQ NNM market maker is to post continuous two-sided quotes (bid and ask), which consist of a price and a size. Between 9:30 a.m. and 4:00 p.m. Eastern time, these quotes must be firm, which means that if any NASD member presents an order to a market maker, the market maker is obligated to trade at terms no worse than its quotes. Failure to do so constitutes “backing away,” which can be subject to regulatory sanction.¹

Other OTC Markets

While the NASDAQ stock markets are the major parts of the U.S. OTC markets, the vast majority of the OTC issues (about 8,000) do not trade on either of the two NASDAQ systems. There are two types of markets for these stocks. The securities traded on these markets are not listed, that is have no listing requirements. Thus, these two OTC markets are not “issuer services.” Rather, they are “subscriber services”—that is, subscribers can make bids and offers for any stock not listed on exchanges or NASDAQ.

The first of these two non-NASDAQ OTC markets is the OTC Bulletin Board (OTCBB), sometimes called simply the “Bulletin Board.” OTCBB is owned and operated by NASDAQ and regulated by NASD. The OTCBB displays real-time quotes, last-sale prices and volume information for approximately 5,500 securities. It includes stocks not traded on NYSE, Amex, or NASDAQ.

The second non-NASDAQ OTC market is the “Pink Sheets,” which is owned and operated by the National Quotation Bureau. Prior to the creation of NASDAQ in 1971, dealer quotations were disseminated by paper copy only. These copies were printed on pink paper for which reason these OTC securities were called “pink sheet stocks.” The Pink Sheets are still published weekly. In addition, an electronic version of the Pink Sheets is updated daily and disseminated over market data vendor terminals. In order to provide greater visibility to these issues, many of which are low priced and thinly traded, transactions in pink sheet issues are subject to price and volume reporting under NASD Schedule D. These pink sheet securities are often pejoratively called “penny stocks.”

These two markets are subscriber markets only-that is, any subscriber can enter quotes for securities on the systems. However, the trades on these markets are executed not on these systems but via the telephone. If the trades are conducted by NASD members, which is usually the case, they are reported to NASD and disseminated by ACT (the NASDAQ trade reporting system).

The OTCBB, however, tends to trade more active stocks than the Pink Sheets. OTCBB trades approximately the most active 4,000 stocks.

The Third Market

A stock may be both listed on an exchange and also traded in the OTC market, called the third market. Like NASDAQ, the third market is a network of broker-dealers that aggregates quotation information and provides inter-participant order routing tools, but leaves order execution to market participants. Dealers that make markets in the third market operate under the regulatory jurisdiction of the NASD. While the third market is not owned by the NASD, market makers in the third market use some of the facilities provided by NASDAQ. When the NASD created NASDAQ in 1971, it included substantially similar functionality for third market listed trading, including the CQS (Consolidated Quotations Service) for third market quotes, and CTS for third market trades, which are discussed below.

Alternative Trading Systems—The Fourth Market

It is not necessary for two parties involved in a transaction to use an intermediary. That is, the services of a broker or a dealer are not required to execute a trade. The direct trading of stocks between two customers without the use of a broker is called the fourth market. This market grew for the same reasons as the third market-the excessively high minimum commissions established by the exchanges.

A number of proprietary alternative trading systems (ATSs), which comprise the fourth market, are operated by the NASD members or member affiliates. These fourth market ATSs are for-profit “broker’s brokers” that match investor orders and report trading activity to the marketplace via NASDAQ or the third market. In a sense, ATSs are similar to exchanges because they are designed to allow two participants to meet directly on the system and are maintained by a third party who also serves a limited regulatory function by imposing requirements on each subscriber.

Broadly, there are two types of ATSs: electronic communications networks and crossing networks.

Electronic Communications Networks

Electronic communications networks (ECNs) are privately owned broker/ dealers that operate as market participants within the NASDAQ system. They display quotes that reflect actual orders and provide institutions and NASDAQ market makers with an anonymous way to enter orders. Essentially, an ECN is a limit order book that is widely disseminated and open for continuous trading to subscribers who may enter and access orders displayed on the ECN. ECNs offer transparency, anonymity, automated service, and reduced prices, and are therefore effective for handling small orders. ECNs are used to disseminate firm commitments to trade (firm bids or offers) to participants, or subscribers, which have typically either purchased or leased hardware for the operation of the ECN or have built a custom connection to the ECN. ECNs may also be linked into the NASDAQ marketplace via a quotation representing the ECN’s best buy and sell quote. In general, ECNs use the internet to link buyers and sellers, bypassing brokers and trading floors.

Since ECNs are part of the NASDAQ execution, their volume is counted as part of the NASDAQ volume. ECNs account for over 30% of NASDAQ trading in exchange trading.

Instinet (Institutional Networks Corporation), the first ECN, began operating in 1969, and continues to be a very large ECN in terms of activity. Instinet was acquired by Reuters Holdings in 1987. Instinet is an NASD member broker-dealer and trades both NASDAQ and exchangelisted stocks. Instinet was originally intended as a system through which institutional investors could cross trades, that is, a crossing network. However, market makers are now significant participants in Instinet. Instinet usage for NASDAQ securities, that is usage as an ECN, began to grow in the mid-1980s when market makers were allowed to subscribe.

Since 1969, nine additional ECNs have been created: Island, Archipelago, REDI Book, Bloomberg Tradebook, BRASS Utility, Strike, Attain, NexTrade, and Market XT. Two of the ECNs, Archipelago and Island, have applied to the SEC to become exchanges.

Crossing Networks

Systems have been developed that allow institutional investors to “cross” trades-that is, match buyers and sellers directly-typically via computer. Crossing networks are batch processes that aggregate orders for execution at prespecified times. Crossing networks provide anonymity and reduced cost, and are specifically designed to minimize a trading cost that we will describe later (market impact cost). They vary considerably in their approach to market structure, including the type of order information that can be entered by the subscriber and the amount of pre-trade transparency that is available to participants.

At present, there are three major crossing networks: ITG Posit, the Arizona Stock Exchange (AZX), and Optimark. Instinet, the original crossing network, operates a fourth crossing network in addition to its current ECN offering.

Instinet is an interactive hit-and-take system, which means that participants search for buyers or sellers electronically, and negotiate and execute trades. It is a computerized execution service, registered with the SEC. The service permits subscribers to search for the opposite side of a trade without the cost of brokerage during Instinet’s evening crossing network. Many mutual funds and other institutional investors use Instinet.

ITG Posit is more than a simple order-matching system. Rather, it matches the purchase and sale of portfolios in a way that optimizes the liquidity of the system. ITG’s hourly POSIT operates only during the trading day.

The AZX in Phoenix, which commenced trading in March 1992, has been an after-hours electronic marketplace where anonymous participants trade stocks via personal computers. This exchange provides a call auction market which accumulates bids and offers for a security and, at designated times, derives a single price that maximizes the number of shares to be traded. It now conducts call auctions at 9:30 a.m., 10:30 a.m., 12:30 p.m., 2:30 p.m., and 4:30 p.m. EST.²

TRADING MECHANICS

Next we describe the key features involved in trading stocks. Later in the chapter, we discuss trading arrangements (block trades and program trades) that developed specifically for coping with the trading needs of institutional investors.

Types of Orders and Trading Priority Rules

When an investor wants to buy or sell a share of common stock, the price and conditions under which the order is to be executed must be communicated to a broker. The simplest type of order is the market order, an order to be executed at the best price available in the market. If the stock is listed and traded on an organized exchange, the best price is assured by the exchange rule that when more than one order on the same side of the buy/ sell transaction reaches the market at the same time, the order with the best price is given priority. Thus, buyers offering a higher price are given priority over those offering a lower price; sellers asking a lower price are given priority over those asking a higher price.

Another priority rule of exchange trading is needed to handle receipt of more than one order at the same price. Most often, the priority in executing such orders is based on the time of arrival of the order-the first orders in are the first orders executed-although there may be a rule that gives higher priority to certain types of market participants over other types of market participants who are seeking to transact at the same price. For example, on exchanges orders can be classified as either public orders or orders of those member firms dealing for their own account (both non-specialists and specialists). Exchange rules require that public orders be given priority over orders of member firms dealing for their own account.

The danger of a market order is that an adverse move may take place between the time the investor places the order and the time the order is executed. To avoid this danger, the investor can place a limit order that designates a price threshold for the execution of the trade. A buy limit order indicates that the stock may be purchased only at the designated price or lower. A sell limit order indicates that the stock may be sold at the designated price or higher. The key disadvantage of a limit order is that there is no guarantee that it will be executed at all; the designated price may simply not be obtainable. A limit order that is not executable at the time it reaches the market is recorded in the limit order book that we mentioned earlier in this chapter.

The limit order is a conditional order: It is executed only if the limit price or a better price can be obtained. Another type of conditional order is the stop order, which specifies that the order is not to be executed until the market moves to a designated price, at which time it becomes a market order. A buy stop order specifies that the order is not to be executed until the market rises to a designated price, that is, until it trades at or above, or is bid at or above, the designated price. A sell stop order specifies that the order is not to be executed until the market price falls below a designated price-that is, until it trades at or below, or is offered at or below, the designated price. A stop order is useful when an investor cannot watch the market constantly. Profits can be preserved or losses minimized on a stock position by allowing market movements to trigger a trade. In a sell (buy) stop order, the designated price is lower (higher) than the current market price of the stock. In a sell (buy) limit order, the designated price is higher (lower) than the current market price of the stock. The relationships between the two types of conditional orders, and the market movements which trigger them, appear in Exhibit 4.1.

There are two dangers associated with stop orders. Stock prices sometimes exhibit abrupt price changes, so the direction of a change in a stock price may be quite temporary, resulting in the premature trading of a stock. Also, once the designated price is reached, the stop order becomes a market order and is subject to the uncertainty of the execution price noted earlier for market orders.

A stop-limit order, a hybrid of a stop order and a limit order, is a stop order that designates a price limit. In contrast to the stop order, which becomes a market order if the stop is reached, the stop-limit order becomes a limit order if the stop is reached. The stop-limit order can be used to cushion the market impact of a stop order. The investor may limit the possible execution price after the activation of the stop. As with a limit order, the limit price may never be reached after the order is activated, which therefore defeats one purpose of the stop order-to protect a profit or limit a loss.

An investor may also enter a market if touched order. This order becomes a market order if a designated price is reached. A market if touched order to buy becomes a market order if the market falls to a given price, while a stop order to buy becomes a market order if the market rises to a given price. Similarly, a market if touched order to sell becomes a market order if the market rises to a specified price, while the stop order to sell becomes a market order if the market falls to a given price. We can think of the stop order as an order designed to get out of an existing position at an acceptable price (without specifying the exact price), and the market if touched order as an order designed to get into a position at an acceptable price (also without specifying the exact price).

Orders may be placed to buy or sell at the open or the close of trading for the day. An opening order indicates a trade to be executed only in the opening range for the day, and a closing order indicates a trade is to be executed only within the closing range for the day.

An investor may enter orders that contain order cancellation provisions. A fill or kill order must be executed as soon as it reaches the trading floor or it is immediately canceled. Orders may designate the time period for which the order is effective-a day, week, or month, or perhaps by a given time within the day. An open order, or good till canceled order, is good until the investor specifically terminates the order.

Orders are also classified by their size. One round lot is typically 100 shares of a stock. An odd lot is defined as less than a round lot. For example, an order of 75 shares of Digital Equipment Corporation (DEC) is an odd lot order. An order of 350 shares of DEC includes an odd lot portion of 50 shares. A block trade is defined on the NYSE as an order of 10,000 shares of a given stock or a total market value of $200,000 or more.

Both the major national stock exchanges and the regional stock exchanges have systems for routing orders of a specified size (that are submitted by brokers) through a computer directly to the specialists’ posts where the orders can be executed. On the NYSE, this system is the SuperDot system. The AMEX’s Post Execution Reporting system allows orders up to 2,000 shares to be routed directly to specialists. The regional stock exchanges have computerized systems for routing small orders to specialists. The Small Order Execution system of the NASDAQ routes and executes orders up to 1,000 shares of a given stock.

Short Selling

Short selling involves the sale of a security not owned by the investor at the time of sale. The investor can arrange to have her broker borrow the stock from someone else, and the borrowed stock is delivered to implement the sale. To cover her short position, the investor must subsequently purchase the stock and return it to the party that lent the stock.

Let us look at an example of how this is done in the stock market. Suppose Ms. Stokes believes that Wilson Steel common stock is overpriced at $20 per share and wants to be in a position to benefit if her assessment is correct. Ms. Stokes calls her broker, Mr. Yats, indicating that she wants to sell 100 shares of Wilson Steel. Mr. Yats will do two things: (1) sell 100 shares of Wilson Steel on behalf of Ms. Stokes, and (2) arrange to borrow 100 shares of that stock to deliver to the buyer. Suppose that Mr. Yats is able to sell the stock for $20 per share and borrows the stock from Mr. Jordan. The shares borrowed from Mr. Jordan will be delivered to the buyer of the 100 shares. The proceeds from the sale (ignoring commissions) will be $2,000. However, the proceeds do not go to Ms. Stokes because she has not given her broker the 100 shares. Thus, Ms. Stokes is said to be “short 100 shares.”

Now, let’s suppose one week later the price of Wilson Steel stock declines to $15 per share. Ms. Stokes may instruct her broker to buy 100 shares of Wilson Steel. The cost of buying the shares (once again ignoring commissions) is $1,500. The shares purchased are then delivered to Mr. Jordan, who lent 100 shares to Ms. Stokes. At this point, Ms. Stokes has sold 100 shares and bought 100 shares. So, she no longer has any obligation to her broker or to Mr. Jordan-she has covered her short position. She is entitled to the funds in her account that were generated by the selling and buying activity. She sold the stock for $2,000 and bought it for $1,500. Thus, she realizes a profit before commissions of $500. From this amount, commissions are subtracted.

Two more costs will reduce the profit further. First, a fee will be charged by the lender of the stock. Second, if there are any dividends paid by Wilson Steel while the stock is borrowed, Ms. Stokes must compensate Mr. Jordan for the dividends he would have been entitled to.

If, instead of falling, the price of Wilson Steel stock rises, Ms. Stokes will realize a loss if she is forced to cover her short position. For example, if the price rises to $27, Ms. Stokes will lose $700, to which must be added commissions and the cost of borrowing the stock (and possibly dividends).

Exchanges impose restrictions as to when a short sale may be executed; these so-called tick-test rules are intended to prevent investors from destabilizing the price of a stock when the market price is falling. A short sale can be made only when either (1) the sale price of the particular stock is higher than the last trade price (referred to as an uptick trade), or (2) if there is no change in the last trade price of the particular stock (referred to as a zero uptick), the previous trade price must be higher than the trade price that preceded it. For example, if Ms. Stokes wanted to short Wilson Steel at a price of $20, and the two previous trade prices were $20⅛, and then $20, she could not do so at this time because of the uptick trade rule. If the previous trade prices were $19⅞, $19⅞, and then $20, she could short the stock at $20 because of the uptick trade rule. Suppose that the sequence of the last three trades is: $19⅞, $20, and $20. Ms. Stokes could short the stock at $20 because of the zero uptick rule.

Margin Transactions

Investors can borrow cash to buy securities and use the securities themselves as collateral. For example, suppose Mr. Boxer has $10,000 to invest and is considering buying Wilson Steel, which is currently selling for $20 per share. With his $10,000, Mr. Boxer can buy 500 shares. Suppose his broker can arrange for him to borrow an additional $10,000 so that Mr. Boxer can buy an additional 500 shares. Thus, with a $20,000 investment, he can purchase a total of 1,000 shares. The 1,000 shares will be used as collateral for the $10,000 borrowed, and Mr. Boxer will have to pay interest on the amount borrowed.

A transaction in which an investor borrows to buy shares using the shares themselves as collateral is called buying on margin. By borrowing funds, an investor creates financial leverage. Note that Mr. Boxer, for a $10,000 investment, realizes the consequences associated with a price change of 1,000 shares rather than 500 shares. He will benefit if the price rises but be worse off if the price falls (compared to borrowing no funds).

To illustrate, we now look at what happens if the price subsequently changes. If the price of Wilson Steel rises to $29 per share, ignoring commissions and the cost of borrowing, Mr. Boxer will realize a profit of $9 per share on 1,000 shares, or $9,000. Had Mr. Boxer not borrowed $10,000 to buy the additional 500 shares, his profit would be only $4,500. Suppose, instead, the price of Wilson Steel stock decreases to $13 per share. Then, by borrowing to buy 500 additional shares, he lost $7 per share on 1,000 shares instead of $7 per share on just 500 shares.

The funds borrowed to buy the additional stock will be provided by the broker, and the broker gets the money from a bank. The interest rate that banks charge brokers for these funds is the call money rate (also labeled the broker loan rate). The broker charges the borrowing investor the call money rate plus a service charge.

Margin Requirements

The brokerage firm is not free to lend as much as it wishes to the investor to buy securities. The Securities Exchange Act of 1934 prohibits brokers from lending more than a specified percentage of the market value of the securities. The initial margin requirement is the proportion of the total market value of the securities that the investor must pay as an equity share, and the remainder is borrowed from the broker. The 1934 act gives the Board of Governors of the Federal Reserve (the Fed) the responsibility to set initial margin requirements. The initial margin requirement has been below 40%, and is 50% as of this writing.

The Fed also establishes a maintenance margin requirement. This is the minimum proportion of (1) the equity in the investor’s margin account to (2) the total market value. If the investor’s margin account falls below the minimum maintenance margin (which would happen if the share price fell), the investor is required to put up additional cash. The investor receives a margin call from the broker specifying the additional cash to be put into the investor’s margin account. If the investor fails to put up the additional cash, the broker has the authority to sell the securities in the investor’s account.

Let us illustrate a maintenance margin. Assume an investor buys 100 shares of stock at $60 per share for $6,000 on 50% margin and the maintenance margin is 25%. By purchasing $6,000 of stock on 50% margin, the investor must put up $3,000 of cash (or other equity) and, thus, borrows $3,000 (referred to as the debit balance).The investor, however, must maintain 25% of margin. To what level must the stock price decline to hit the maintenance margin level? The price is $40. At this price, the stock position has a value of $4,000 ($40 × 100 shares). With a loan of $3,000, the equity in the account is $1,000 ($4,000 − $3,000), or 25% of the account value ($1,000/$4,000 = 25%). If the price of the stock decreases below $40, the investor must deposit more equity to bring the equity level up to 25%. In general, if the maintenance margin is 25%, the account level has to decrease to 4/3 times the amount borrowed (the debit balance) to reach the minimum maintenance margin level.

There are also margin requirements for short selling. Consider a similar margin example for a short position. An investor shorts (borrows and sells) 100 shares of stock at $60 for total stock value of $6,000.With an initial margin of 50%, the investor must deposit $3,000 (in addition to leaving the $6,000 from the sale in the account).This leaves the investor with a credit balance of $9,000 (which does not change with the stock price since it is in cash). However, the investor owes 100 shares of the stock at the current market price. To what level must the stock price increase to hit the maintenance margin level, assumed to be 30% (which is the equity in the account as a percentage of the market value of the stock)? The answer is $69.23, for a total stock value of $6,923. If the stock is worth $6,923, there is $2,077 of equity in the account ($9,000 − $6,923), which represents 30% of the market value of the stock ($2,077/ $6,923 = 30%). If the maintenance margin is 30%, the value of the stock which triggers the maintenance level is calculated by multiplying the credit balance by 10/13 (10/13 × $9,000 = $6,923).

A summary of the long and short margin requirements is provided below:

TRADING COSTS

An important aspect of an investment strategy is controlling the trading costs necessary to implement the strategy. The measurement of trading costs is, while important, very difficult.

We begin by defining trading costs. Trading costs can be decomposed into two major components: explicit costs and implicit costs. Explicit costs are the direct costs of trading, such as broker commissions, fees, and taxes. Implicit costs represent such indirect costs as the price impact of the trade and the opportunity costs of failing to execute in a timely manner or at all. Whereas explicit costs are associated with identifiable accounting charges, no such reporting of implicit costs occurs.

Explicit Costs

The main explicit cost is the commission paid to the broker for execution. Commission costs are fully negotiable and vary systematically by broker type and market mechanism. The commission may depend on both the price per share and the number of shares in the transaction.³ In addition to commissions, there may be other explicit costs. These explicit costs include custodial fees (the fees charged by an institution that holds securities in safekeeping for an investor) and transfer fees (the fees associated from transferring an asset from one owner to another).

Since the introduction of negotiated commissions in May 1975, the opportunity has arisen for the development of discount brokers. These brokers charge commissions at rates much less than those charged by other brokers, but offer little or no advice or any other service apart from execution of the transaction.

In general, commissions began a downward trend in 1975 which continued through 1996, when they reached 4.50¢ per share. Based on a study by the Plexus Group, after increasing during 1997, commissions reached 4.5¢ per share again in the first quarter of 1999. Only small, easily traded orders have become cheaper, not the larger and more difficult trades. Commissions for larger trades (over 10,000 shares) have been relatively stable at about 4.80¢ per share. Commissions for trades under 10,000 shares on the other hand, have declined to 2.80¢ per share.⁴

The Plexus Group study also found that the commissions on capital committing trades-trades that require a commitment of the dealer’s own capital to accomplish the trade rather than simply executing the trade by matching two customer orders on an agency basis-are higher and have not declined. Investors should expect to pay for the use of the dealer’s capital and the associated risk. Similarly, soft dollar trades, discussed below, have high and stable commissions. Consequently, investors may be penalized for not being able to “shop around” for lower commissions. Overall, it is the commissions on agency trades (trades on which the dealer need not commit capital) and non-soft dollar trades (for which the customer can shop around) that are the lowest and have declined the most.

There are also two other issues that relate to transactions costs- “soft dollars” and “payment for order flow.” These issues are discussed in the following sections.

Soft Dollars

Investors often choose their broker/dealer based on who will give them the best execution at the lowest transaction cost on a specific transaction, and also based on who will provide complementary services (such as research) over a period of time. Order flow can also be “purchased” by a broker/dealer from an investor with “soft dollars.” In this case, the broker/dealer provides the investor, without explicit charge, services such as research or electronic services, typically from a third party for which the investor would otherwise have had to pay “hard dollars” to the third party, in exchange for the investor’s order flow. Of course, the investor pays the broker/dealer for the execution service.

According to such a relationship, the investor preferentially routes their order to the broker/dealer specified in the soft dollar relationship and does not have to pay “hard dollars,” or real money, for the research or other services. This practice is called paying “soft dollars” (i.e., directing their order flow) for the ancillary research. For example, client A preferentially directs his order flow to broker/dealer B (often a specified amount of order flow over a specified period, such as a month or year) and pays the broker/dealer for these execution services. In turn, broker/ dealer B pays for some research services provided to client A. Very often the research provider is a separate firm, say, firm C. Thus, soft dollars refer to money paid by an investor to a broker/dealer or a third party through commission revenue rather than by direct payments.

The disadvantage to the broker/dealer is that they have to pay hard dollars (to the research provider) for the client’s order flow. The disadvantage to the client is that they are not free to “shop around” for the best bid or best offer, net of commissions, for all their transactions, but have to do an agreed amount of transaction volume with the specific broker/dealer. In addition, the research provider may give a preferential price to the broker/ dealer. Thus, each of these participants in the soft dollar relationship experiences some advantage, but also an offsetting disadvantage.

The SEC has imposed formal and informal limitations on the type and amount of soft dollar business institutional investors can conduct. For example, while an institutional investor can accept research in a soft dollar relationship, they cannot accept furniture or vacations. SEC disclosure rules, passed in 1995, require investment advisors to disclose, among other things, the details on any product or services received through soft dollars.

Payment for Order Flow

In payment for order flow arrangements, an OTC market maker may offer a cash payment to other brokerage firms which have customer order flow in exchange for the right to execute the broker’s order flow, thus providing a reason for the broker preferencing trades to certain market makers for each stock. Such payment for order flow has occurred mainly on NASDAQ on which there are several market makers for each stock. Rebates are typically on a per-share basis and have historically been about 2¢ a share.

The reasons for payment for order flow remain controversial. One possible reason is that it is a device for price discrimination based on the information content of the order. Specifically, market makers may pay for orders that are placed by “uninformed traders,” and hence are more profitable to execute; but they may not pay for orders placed by “informed traders,” which are less profitable. In general, retail order flow is considered to be uninformed, and institutional and professional order flow to be informed. In fact, most payment for order flow arrangements are with retail brokerage houses and the average size of purchased orders is significantly below the overall average trade size. Obviously small retail trades are preferred by the market makers who pay for order flow and are considered uninformed order flow. The data appear to be consistent with the uniformed/informed trader hypothesis.

Inter-market market-maker competition and inter-exchange competition via payment for order flow remains controversial.⁵ The relevant policy question is whether retail broker/dealers are diverted from sending their retail orders to the best markets, thereby disadvantaging their customers, or whether a portion of the payment accrues to the customer, thereby benefiting the customer. The advent of decimalization during 2000, discussed later, has permitted smaller bid/offer spreads and has reduced the degree of payment for order flow. Overall, both soft dollars and payment for order flow remain controversial.

Implicit Costs

Implicit trading costs include impact costs, timing costs, and opportunity costs.

Impact Costs

The impact cost of a transaction is the change in market price due to supply/ demand imbalances as a result of the trade. Bid-ask spread estimates, although informative, fail to capture the fact that large trades-those that exceed the number of shares the market maker is willing to trade at the quoted bid and ask prices-may move prices in the direction of the trade. That is, large trades may increase the price for buy orders and decrease the price for sell orders. The resulting market impact or price impact of the transaction can be thought of as the deviation of the transaction price from the “unperturbed price” that would have prevailed had the trade not occurred. As discussed above, crossing networks are designed to minimize impact costs.

Timing Cost

The timing cost is measured as the price change between the time the parties to the implementation process assume responsibility for the trade and the time they complete the responsibility. Timing costs occur when orders are on the trading desk of a buy side firm (e.g., an investment management firm), but have not been released to the broker because the trader fears that the trade may swamp the market.

Opportunity Costs

The opportunity cost is the “cost” of securities not traded. This cost results from missed or only partially completed trades. These costs are the natural consequence of the release delays. For example, if the price moves too much before the trade can be completed, the manager will not make the trade. In practice, this cost is measured on shares not traded based on the difference between the market price at the time of decision and the closing price 30 days later.

While commissions and impact costs are actual and visible out-of-pocket costs, opportunity costs and timing costs are the costs of foregone opportunities and are invisible. Opportunity costs can arise for two reasons. First, some orders are executed with a delay, during which the price may move against the investor. Second, some orders incur an opportunity cost because they are only partially filled or are not executed at all.

Classification of Trading Costs

We have thus far classified four main trading costs-commissions, impact costs, timing costs, and opportunity costs-as explicit or implicit trading costs. This categorization is based on whether or not the costs are identifiable accounting costs. Another categorization of these costs is execution costs versus opportunity costs. This categorization is based on whether or not the trades are completed. A schematic diagram of trading costs using this categorization is shown in Exhibit 4.2.

The categorization of the four costs according to the two criteria is as follows.

Source: “Alpha Capture,” Plexus Group, Second Quarter, 1999.

Research on Transaction Costs

Overall, while the trading commission is the most obvious, measurable, and discussed trading cost, it is only one of the four types of trading costs and, in fact, as discussed below, may be the smallest. The implicit trading costs are much more difficult to measure.

Recent studies in transactions costs allow several conclusions. They are:

1. Although considerable debate still surrounds how to measure trading costs, the consensus is that implicit trading costs are economically significant relative to explicit costs (and also relative to realized portfolio returns).
2. Equity trading costs vary systematically with trade difficulty and order-placement strategy.
3. Differences in market design, investment style, trading ability, and reputation are important determinants of trading costs.
4. Even after researchers control for trade complexity and trade venue, trading costs are found to vary considerably among managers.
5. Accurate prediction of trading costs requires more detailed data on the entire order-submission process than are generally available, especially information on pre-trade decision variables.

These findings suggest that the concept of “best execution” for institutional traders is difficult to measure and hence to enforce.⁶

TRADING ARRANGEMENTS FOR RETAIL AND INSTITUTIONAL INVESTORS

Trades are executed by both individuals, called retail investors, and institutions. There are several differences in the way each group trades. The first is size: institutions typically transact much larger orders than individuals. The second is commissions: consistent with their larger size, institutions typically pay lower commissions than individuals. While institutional commissions have declined since 1975, some retail commissions have also declined significantly recently as a result of the advent of discount brokers, as discussed in the next section.

The third difference is the method of order execution. While both an individual and an institution may trade through a broker/dealer, the manner in which their orders are entered and executed may be considerably different, even if the trades are through the same broker/dealer. An individual trading through a broker/dealer typically goes through a stockbroker (financial consultant). These orders go to a retail exchange execution desk and from there to the NYSE (usually through SuperDot) or to the OTC execution desk where it will be transacted with another market maker on NASDAQ.

Retail investors receive a “confirm” (confirmation) of the trade, typically in the mail. Institutional investors generally give their order directly to the institutional broker/dealer execution desk for both exchange and OTC orders. Exchange orders may be sent to the broker/ dealer’s floor broker, and OTC orders may be transacted with another broker/dealer or internalized at a competitive bid/offer. Competing bids or offers are typically obtained in all cases.

Retail Stock Trading

Historically, there has been a decline in the direct household ownership of common stocks. This decline does not necessarily lead to the conclusion that households have decreased their common stock holdings. Rather, it means that households are holding more of their common stock through intermediaries such as mutual funds rather than directly in the form of common stock. While households hold more total common stock than before, they hold less common stock directly, and thus, increasingly the stock executions are done by institutions, such as mutual funds, rather than by individuals.

One of the reasons for individuals owning stocks through mutual funds rather than directly involves transaction costs; that is, institutions can transact stocks more cheaply than individuals.While this advantage for institutions remains, transaction costs for individuals have declined significantly during the last decade.

Since May Day 1975, stock trading commissions have declined both for institutions and individuals. However, prior to 1990, individuals traded stocks mainly through so-called “full service brokers,” where commissions reflected not only the stock trade execution, but also the counsel of a stockbroker and perhaps research. The largest full-service broker/ dealers are also known as “wirehouses.” These firms typically do institutional trading and investment banking as well as retail business. The commissions for these full service brokers have declined since 1975.

However, in addition, a “discount broker” industry developed in which the stockbroker provided no advice and no research. Individuals entered their orders via a telephone. More recently, individuals could enter their orders via their personal computer-these are called “online” or “Web based” brokerage firms. Consistent with the lower provision of service by discount brokers and online brokers, stock trading commissions decreased significantly. Thus, individuals could trade and own stocks more efficiently.

To remain competitive to a wide range of clients in this environment, the traditional full service brokerage firms responded by offering customers alternative means of transacting common stock. For example, many full service brokerage firms offer the traditional services of a stockbroker and research at a high commission, and, in addition, offer direct order entry only at a lower commission. On the other hand, some discount brokers have begun to offer more service at a higher commission.

Thus, there continue to be ebbs and flows in the balance between more service and low commissions in the retail trading of common stock. Both online brokers, who offer no service and low commissions, and managers of segregated accounts, who offer enhanced services for a large fee, are growing along with full service stock brokerages and mutual funds.

Despite paying higher commissions than institutions, individual investors may have some advantages over institutions. Because individuals usually transact smaller orders, they will incur smaller impact costs. In addition, if individual investors transact online, they may have shorter time lags. It is for these and other reasons that “packaged products” of individual stocks such as “folios” are becoming more attractive.

Institutional Trading

With the increase in trading by institutional investors, trading arrangements more suitable to these investors were developed. Institutional needs included trading in large size and trading groups of stocks, both at a low commission and with low market impact. This has resulted in the evolution of special arrangements for the execution of certain types of orders commonly sought by institutional investors: (1) orders requiring the execution of a trade of a large number of shares of a given stock and (2) orders requiring the execution of trades in a large number of different stocks at as near the same time as possible. The former types of trades are called block trades; the latter are called program trades. An example of a block trade would be a mutual fund seeking to buy 15,000 shares of IBM stock. An example of a program trade would be a pension fund wanting to buy shares of 200 names (companies) at the end of a trading day (“at the close”).

The institutional arrangement that has evolved to accommodate these two types of institutional trades is the development of a network of trading desks of the major securities firms and other institutional investors that communicate with each other by means of electronic display systems and telephones. This network is referred to as the upstairs market. Participants in the upstairs market play a key role by (1) providing liquidity to the market so that such institutional trades can be executed, and (2) by arbitrage activities that help to integrate the fragmented stock market.

Block Trades

On the NYSE, block trades are defined as either trades of at least 10,000 shares of a given stock, or trades of shares with a market value of at least $200,000, whichever is less. Since the execution of large numbers of block orders places strains on the specialist system in the NYSE, special procedures have been developed to handle them. Typically, an institutional customer contacts its salesperson at a brokerage firm, indicating that it wishes to place a block order. The salesperson then gives the order to the block execution department of the brokerage firm. Note that the salesperson does not submit the order to be executed to the exchange where the stock might be traded or, in the case of an unlisted stock, try to execute the order on the NASDAQ system. The sales traders in the block execution department contact other institutions to attempt to find one or more institutions that would be willing to take the other side of the order. That is, they use the upstairs market in their search to fill the block trade order. If this can be accomplished, the execution of the order is completed.

If the sales traders cannot find enough institutions to take the entire block (for example, if the block trade order is for 40,000 shares of IBM, but only 25,000 can be “crossed” with other institutions), then the balance of the block trade order is given to the firm’s market maker. The market maker must then make a decision as to how to handle the balance of the block trade order. There are two choices. First, the brokerage firm may take a position in the stock and buy the shares for its own account. Second, the unfilled order may be executed by using the services of competing market makers. In the former case, the brokerage firm is committing its own capital.

NYSE Rule 127 states that if a member firm receives an order for a large block of stock that might not be readily absorbed by the market, the member firm should nevertheless explore the market on the floor, including, where appropriate, consulting with the specialist as to his interest in the security. If a member firm intends to cross a large block of stock for a public account at a price that is outside of the current quote, it should inform the specialist of its intention.

Program Trades

Program trades involve the buying and/or selling of a large number of names simultaneously. Such trades are also called basket trades because effectively a “basket” of stocks is being traded. The NYSE defines a program trade as any trade involving the purchase or sale of a basket of at least 15 stocks with a total value of $1 million or more.

The two major applications of program trades are asset allocation and index arbitrage. With respect to asset allocation trades, some examples of why an institutional investor may want to use a program trade are deployment of new cash into the stock market; implementation of a decision to move funds invested in the bond market to the stock market (or vice versa); and rebalancing the composition of a stock portfolio because of a change in investment strategy. A mutual fund money manager can, for example, move funds quickly into or out of the stock market for an entire portfolio of stocks through a single program trade. All these strategies are related to asset allocation.

The growth of mutual fund sales and massive equity investments by pension funds and insurance companies during the 1990s have all given an impetus to such methods to trade baskets or bundles of stocks efficiently. Other reasons for which an institutional investor may have a need to execute a program trade should be apparent later when we discuss an investment strategy called indexing.

There are several commission arrangements available to an institution for a program trade, and each arrangement has numerous variants. Considerations in selecting one (in addition to commission costs) are the risk of failing to realize the best execution price, and the risk that the brokerage firms to be solicited about executing the program trade will use their knowledge of the program trade to benefit from the anticipated price movement that might result-in other words, that they will frontrun the transaction (for example, buying a stock for their own account before filling the customer buy order).

From a dealer’s perspective, program trades can be conducted in two ways, namely on an agency basis and on a principal basis. An intermediate type of program trade, the agency incentive arrangement, is an additional alternative. A program trade executed on an agency basis involves the selection by the investor of a brokerage firm solely on the basis of commission bids (cents per share) submitted by various brokerage firms. The brokerage firm selected uses its best efforts as an agent of the institution to obtain the best price. Such trades have low explicit commissions. To the investor, the disadvantage of the agency program trade is that, while commissions may be the lowest, the execution price may not be the best because of impact costs and the potential frontrunning by the brokerage firms solicited to submit a commission bid. The investor knows in advance the commission paid, but does not know the price at which the trades will be executed. Another disadvantage is that there is increased risk of adverse selection of the counter-party in the execution process.

Related to the agency basis is an agency incentive arrangement, in which a benchmark portfolio value is established for the group of stocks in the program trade. The price for each “name” (i.e., specific stock) in the program trade is determined as either the price at the end of the previous day or the average price of the previous day. If the brokerage firm can execute the trade on the next trading day such that a better-than-benchmark portfolio value results—a higher value in the case of a program trade involving selling, or a lower value in the case of a program trade involving buying—then the brokerage firm receives the specified commission plus some predetermined additional compensation. In this case the investor does not know in advance the commission or the execution price precisely, but has a reasonable expectation that the price will be better than a threshold level.

What if the brokerage firm does not achieve the benchmark portfolio value? It is in such a case that the variants come into play. One arrangement may call for the brokerage firm to receive only the previously agreed-upon commission. Other arrangements may involve sharing the risk of not realizing the benchmark portfolio value with the brokerage firm. That is, if the brokerage firm falls short of the benchmark portfolio value, it must absorb a portion of the shortfall. In these risk-sharing arrangements, the brokerage firm is risking its own capital. The greater the risk sharing the brokerage firm must accept, the higher the commission it will charge.

The brokerage firm can also choose to execute the trade on a principal basis. In this case, the dealer would commit its own capital to buy or sell the portfolio and complete the investor’s transaction immediately. Since the dealer incurs market risk, it would also charge higher commissions. The key factors in pricing principal trades are: liquidity characteristics, absolute dollar value, nature of the trade, customer profile, and market volatility. In this case, the investor knows the trade execution price in advance, but pays a higher commission.

To minimize frontrunning, institutions often use other types of program trade arrangements. They call for brokerage firms to receive, not specific names and quantities of stocks, but only aggregate statistical information about key portfolio parameters. Several brokerage firms then bid on a cents per share basis on the entire portfolio (also called “blind baskets”), guaranteeing execution at either closing price (termed “market-at-close”) or a particular intra-day price to the customer. Note that this is a principal trade. Since mutual fund net asset values are calculated using closing prices, a mutual fund that follows an indexing strategy (i.e., an index fund), for instance, would want guaranteed market-at-close execution to minimize the risk of not performing as well as the stock index. When the winning bidder has been selected, it receives the details of the portfolio. While the commission in this type of transaction is higher, this procedure increases the risk to the brokerage firm of successfully executing the program trade. However, the brokerage firm can use stock index futures to protect itself from market-wide movements if the characteristics of the portfolio in the program trade are similar to the index underlying the stock index futures contract.

PRICE LIMITS AND COLLARS

Trading or price limits specify a minimum price limit below which the market price index level may not decline due to an institutionally mandated termination of trading, at least at prices below the specified price (the price limit) for a specified period of time. For example, if the Dow Jones Industrial Average (DJIA) was trading at 11,000 and its price limit was 500 points below that, then no trades could occur below 10,500. This pause in trading is intended to “give the market a breather” to at least calm emotions. Trading limits had previously been used in the futures markets but not in the stock market.

These price limits have been modified several times since their implementation soon after the stock market crash of 1987. Two different types of price limits are discussed below.

Rule 80B or “Circuit Breakers”

On April 15, 1998, the NYSE implemented new regulations to increase and widen thresholds at which trading is halted for single-day declines in the DJIA. The point levels are set quarterly at 10%, 20%, and 30% of the DJIA by using the DJIA average closing value of the previous month, rounded to the nearest 50 points. Point levels are adjusted on January 1, April 1, July 1, and October 1.

Rule 80A or “Trading Collar”

Another type of trading restriction applies to index arbitrage trading whereby, for example, a basket of S&P 500 stocks is bought (sold) against the sale (purchase) of an S&P 500 futures contract. On February 16, 1999, following approval by the SEC, the NYSE implemented revisions to Rule 80A, which restricts index arbitrage trading. Specifically, the set 50-point collar was eliminated and the trigger level was allowed to track the DJIA. The revised collar is calculated quarterly as 2% of the average closing value of the DJIA for the last month of the previous quarter, rounded down to the nearest 10 points and is currently implemented as follows:

• A decline in the DJIA of 210 points or more requires all index arbitrage sell orders of the S&P 500 stocks to be stabilizing, or “sell plus,” for the remainder of the day, unless on the same trading day, the DJIA advances to a value of 100 points or less below its previous close.
• An advance in the DJIA of 210 points requires all index arbitrage buy orders of the S&P 500 stocks to be stabilizing, or “buy minus,” for the remainder of the day, unless the DJIA retreats to 100 points or less above its previous close.
• The restrictions will be reimposed each time the DJIA advances or declines the predetermined amount.

STOCK MARKET INDICATORS

Stock market indicators have come to perform a variety of functions, from serving as benchmarks for evaluating the performance of professional money managers to answering the question “How did the market do today?” Thus, stock market indicators (indexes or averages) have become a part of everyday life. Even though many of the stock market indicators are used interchangeably, it is important to realize that each indicator applies to, and measures, a different facet of the stock market.

The most commonly quoted stock market indicator is the DJIA. Other popular stock market indicators cited in the financial press are the Standard & Poor’s 500 Composite (S&P 500), the New York Stock Exchange Composite Index (NYSE Composite), the NASDAQ Composite Index, and the Value Line Composite Average (VLCA). There are a myriad of other stock market indicators such as the Wilshire stock indexes and the Russell stock indexes, which are followed primarily by institutional money managers.

In general, market indexes rise and fall in fairly similar patterns. Although the correlations among indexes are high, the indexes do not move in exactly the same way at all times. The differences in movement reflect the different manner in which the indexes are constructed. Three factors enter into that construction: the universe of stocks represented by the sample underlying the index, the relative weights assigned to the stocks included in the index, and the method of averaging across all the stocks.

Some indexes represent only stocks listed on an exchange. Examples are the DJIA and the NYSE Composite, which represent only stocks listed on the NYSE or Big Board. By contrast, the NASDAQ includes only stocks traded over the counter. A favorite of professionals is the S&P 500 because it is a broader index containing both NYSE-listed and OTC-traded shares. Each index relies on a sample of stocks from its universe, and that sample may be small or quite large. The DJIA uses only 30 of the NYSE-traded shares, while the NYSE Composite includes every one of the listed shares. The NASDAQ also includes all shares in its universe, while the S&P 500 has a sample that contains only 500 of the more than 8,000 shares in the universe it represents.

The stocks included in a stock market index must be combined in certain proportions, and each stock must be given a weight. The three main approaches to weighting are: (1) weighting by the market capitalization, which is the value of the number of shares times price per share; (2) weighting by the price of the stock; and (3) equal weighting for each stock, regardless of its price or its firm’s market value. With the exception of the Dow Jones averages (such as the DJIA) and the VLCA, nearly all of the most widely used indexes are market-value weighted. The DJIA is a priceweighted average, and the VLCA is an equally weighted index.

Stock market indicators can be classified into three groups: (1) those produced by stock exchanges based on all stocks traded on the exchanges; (2) those produced by organizations that subjectively select the stocks to be included in indexes; and (3) those where stock selection is based on an objective measure, such as the market capitalization of the company. The first group includes the New York Stock Exchange Composite Index, which reflects the market value of all stocks traded on the NYSE. While it is not an exchange, the NASDAQ Composite Index falls into this category because the index represents all stocks traded on the NASDAQ system.

The three most popular stock market indicators in the second group are the Dow Jones Industrial Average, the Standard & Poor’s 500, and the Value Line Composite Average. The DJIA is constructed from 30 of the largest blue-chip industrial companies traded on the NYSE. The companies included in the average are those selected by Dow Jones & Company, publisher of the Wall Street Journal. The S&P 500 represents stocks chosen from the two major national stock exchanges and the over-the-counter market. The stocks in the index at any given time are determined by a committee of Standard & Poor’s Corporation, which may occasionally add or delete individual stocks or the stocks of entire industry groups. The aim of the committee is to capture present overall stock market conditions as reflected in a very broad range of economic indicators. The VLCA, produced by Value Line Inc., covers a broad range of widely held and actively traded NYSE, AMEX, and OTC issues selected by Value Line.

In the third group we have the Wilshire indexes produced by Wilshire Associates (Santa Monica, California) and Russell indexes produced by the Frank Russell Company (Tacoma, Washington), a consultant to pension funds and other institutional investors. The criterion for inclusion in each of these indexes is solely a firm’s market capitalization. The most comprehensive index is the Wilshire 5000, which actually includes more than 6,700 stocks now, up from 5,000 at its inception. The Wilshire 4500 includes all stocks in the Wilshire 5000 except for those in the S&P 500. Thus, the shares in the Wilshire 4500 have smaller capitalization than those in the Wilshire 5000. The Russell 3000 encompasses the 3,000 largest companies in terms of their market capitalization. The Russell 1000 is limited to the largest 1,000 of those, and the Russell 2000 has the remaining smaller firms.

Two methods of averaging may be used. The first and most common is the arithmetic average. An arithmetic mean is just a simple average of the stocks, calculated by summing them (after weighting, if appropriate) and dividing by the sum of the weights. The second method is the geometric mean, which involves multiplication of the components, after which the product is raised to the power of 1 divided by the number of components.

PRICING EFFICIENCY OF THE STOCK MARKET

A price efficient market is one in which security prices at all times fully reflect all available information that is relevant to their valuation. When a market is price efficient, investment strategies pursued to outperform a broad-based stock market index will not consistently produce superior returns after adjusting for (1) risk and (2) transaction costs.

Numerous studies have examined the pricing efficiency of the stock market. While it is not our intent in this chapter to provide a comprehensive review of these studies, we can summarize the basic findings and implications for investment strategies.

Forms of Efficiency

There are three different forms of pricing efficiency: (1) weak form, (2) semistrong form, and (3) strong form.⁷ The distinctions among these forms rests in the relevant information that is believed to be taken into consideration in the price of the security at all times. Weak-form efficiency means that the price of the security reflects the past price and trading history of the security. Semistrong-form efficiency means that the price of the security fully reflects all public information (which, of course, includes but is not limited to, historical price and trading patterns). Strong-form efficiency exists in a market where the price of a security reflects all information, whether it is publicly available or known only to insiders such as the firm’s managers or directors.

The preponderance of empirical evidence supports the claim that developed common stock markets are efficient in the weak form. The evidence emerges from numerous sophisticated tests that explore whether or not historical price movements can be used to project future prices in such a way as to produce returns above what one would expect from market movements and the risk class of the security. Such returns are known as positive abnormal returns. The implications are that investors who follow a strategy of selecting stocks solely on the basis of price patterns or trading volume-such investors are referred to as technical analysts or chartists-should not expect to do better than the market. In fact, they may fare worse because of the higher transaction costs associated with frequent buying and selling of stocks.

Evidence on price efficiency in the semi-strong form is mixed. Some studies support the proposition of efficiency when they suggest that investors who select stocks on the basis of fundamental security analysis—which consists of analyzing financial statements, the quality of management, and the economic environment of a company-will not outperform the market. This result is certainly reasonable. There are so many analysts using the same approach, with the same publicly available data, that the price of the stock remains in line with all the relevant factors that determine value. On the other hand, a sizable number of studies have produced evidence indicating that there have been instances and patterns of pricing inefficiency in the stock market over long periods of time. Economists and financial analysts often label these examples of inefficient pricing as anomalies in the market, that is, phenomena that cannot be easily explained by accepted theory.

Empirical tests of strong form pricing efficiency fall into two groups: (1) studies of the performance of professional money managers, and (2) studies of the activities of insiders (individuals who are either company directors, major officers, or major stockholders). Studying the performance of professional money managers to test the strong form of pricing efficiency has been based on the belief that professional managers have access to better information than the general public. Whether or not this is true is moot because the empirical evidence suggests professional managers have been unable to outperform the market consistently. In contrast, evidence based on the activities of insiders has generally revealed that this group often achieves higher risk-adjusted returns than the stock market. Of course, insiders could not consistently earn those high abnormal returns if the stock prices fully reflected all relevant information about the values of the firms. Thus, the empirical evidence on insiders argues against the notion that the market is efficient in the strong-form sense.

Implications for Investing in Common Stock

Common stock investment strategies can be classified into two general categories: active strategies and passive strategies. Active strategies are those that attempt to outperform the market by one or more of the following: (1) timing the selection of transactions, such as in the case of technical analysis, (2) identifying undervalued or overvalued stocks using fundamental security analysis, or (3) selecting stocks according to one of the market anomalies. Obviously, the decision to pursue an active strategy must be based on the belief that there is some type of gain from such costly efforts, but gains are possible only if pricing inefficiencies exist. The particular strategy chosen depends on why the investor believes this is the case.

Investors who believe that the market prices stocks efficiently should accept the implication that attempts to outperform the market cannot be systematically successful, except by luck. This implication does not mean that investors should shun the stock market, but rather that they should pursue a passive strategy, one that does not attempt to outperform the market. Is there an optimal investment strategy for someone who holds this belief in the pricing efficiency of the stock market? Indeed there is. The theoretical basis rests on modern portfolio theory and capital market theory. According to modern portfolio theory, the market portfolio offers the highest level of return per unit of risk in a market that is price efficient. A portfolio of financial assets with characteristics similar to those of a portfolio consisting of the entire market-the market portfolio-will capture the pricing efficiency of the market.

But how can such a passive strategy be implemented? More specifically, what is meant by a market portfolio, and how should that portfolio be constructed? In theory, the market portfolio consists of all financial assets, not just common stock. The reason is that investors compare all investment opportunities, not just stock, when committing their capital. Thus, our principles of investing must be based on capital market theory, not just stock market theory. When the theory is applied to the stock market, the market portfolio has been defined as consisting of a large universe of common stocks. But how much of each common stock should be purchased when constructing the market portfolio? Theory states that the chosen portfolio should be an appropriate fraction of the market portfolio; hence, the weighting of each stock in the market portfolio should be based on its relative market capitalization. Thus, if the aggregate market capitalization of all stocks included in the market portfolio is $T and the market capitalization of one of these stocks is $A, then the fraction of this stock that should be held in the market portfolio is $A/$T.

The passive strategy that we have just described is called indexing. As pension fund sponsors in the 1990s increasingly came to believe that money managers were unable to outperform the stock market, the amount of funds managed using an indexing strategy has grown substantially.

OVERVIEW OF COMMON STOCK PORTFOLIO MANAGEMENT

In this section we provide an overview of common stock portfolio management and then describe the various strategies pursued by money managers and the evidence on the performance of such strategies. Basically, these strategies can be classified into one of two types: active and passive. The selection of a strategy depends on two factors. The first is the risk tolerance of the investor. The second is the investor’s view of the efficiency of the stock market. If an investor believes the stock market is efficient, he would tend to favor a passive strategy; an investor who believes the stock market is inefficient will embrace an active strategy.

Overview of Active Portfolio Management

A useful way of thinking about active versus passive management is in terms of the following three activities performed by investors: (1) portfolio construction (deciding on the stocks to buy and sell), (2) trading of securities, and (3) portfolio monitoring.⁸ Generally, investors pursuing active strategies devote the majority of their time to portfolio construction. In contrast, with passive strategies such as indexing (discussed later), investors devote less time to this activity.

Top-Down versus Bottom-Up Approaches

An investor who pursues active management may follow either a top-down or bottom-up approach. With a top-down approach, an investor begins by assessing the macroeconomic environment and forecasting its near-term outlook. Based on this assessment and forecast, an investor decides on how much of the portfolio’s funds to allocate among the different sectors of the common stock market and how much to allocate to cash equivalents (i.e., short-term money market instruments). The sectors of the common stock market can be classified as follows: basic materials, communications, consumer staples, financials, technology, utilities, capital goods, consumer cyclicals, energy, health care, and transportation. Industry classifications give a finer breakdown and include, for example, aluminum, paper, international oil, beverages, electric utilities, telephone and telegraph, and so forth.

In making the allocation decision, an investor who follows a top-down approach relies on an analysis of the common stock market to identify those sectors and industries that will benefit the most on a relative basis from the anticipated economic forecast. Once the amount to be allocated to each sector and industry is made, the investor then looks for the individual stocks to include in the portfolio.

In contrast to the top-down approach, an investor who follows a bottom-up approach focuses on the analysis of individual stocks and gives little weight to the significance of economic and market cycles. The primary tool of the investor who pursues a bottom-up approach is fundamental security analysis. The product of the analysis is a set of potential stocks to purchase that have certain characteristics that the manager views as being attractive. For example, these characteristics can be a low price-earnings ratio or small market capitalization.

Within the top-down and bottom-up approaches there are different strategies pursued by active equity managers. These strategies are often referred to as “equity styles” which we describe later when we discuss equity style management.

Fundamental versus Technical Analysis

Also within the top-down and bottom-up approaches to active management are two camps as to what information is useful in the selection of stocks and the timing of the purchase of stocks. These two camps are the fundamental analysis camp and the technical analysis camp.

Traditional fundamental analysis involves the analysis of a company’s operations to assess its economic prospects. The analysis begins with the financial statements of the company in order to investigate the earnings, cash flow, profitability, and debt burden. The fundamental analyst will look at the major product lines, the economic outlook for the products (including existing and potential competitors), and the industries in which the company operates. The results of this analysis will be an assessment of the growth prospects of earnings. Based on the growth prospects of earnings, a fundamental analyst attempts to determine the fair value of the stock using one or more common stock valuation models (i.e., dividend discount models and asset pricing models which we discussed in Chapter 2). The estimated fair value is then compared to the market price to determine if the stock is fairly priced in the market, cheap (a market price below the estimated fair value), or rich (a market price above the estimated fair value).⁹

Technical analysis ignores company information regarding the economics of the firm. Instead, technical analysis focuses on price and/or trading volume of individual stocks, groups of stocks, and the market overall resulting from shifting supply and demand. This type of analysis is not only used for the analysis of common stock, but it is also a tool used in the trading of commodities, bonds, and futures contracts.

Fundamental analysis and technical analysis can be integrated within a strategy. Specifically, an investor can use fundamental analysis to identify stocks that are candidates for purchase or sale and employ technical analysis to time the purchase or sale.

Popular Active Stock Market Strategies

Throughout the history of the stock market there have been numerous strategies suggested about how to “beat the market.” Below we describe several popular stock market strategies.

Strategies Based on Technical Analysis

Various common stock strategies that involve only historical price movement, trading volume, and other technical indicators have been suggested since the beginning of stock trading in the United States, as well as in commodity and other markets throughout the world. Many of these strategies involve investigating patterns based on historical trading data (past price data and trading volume) to forecast the future movement of individual stocks or the market as a whole. Based on observed patterns, mechanical trading rules indicating when a stock should be bought, sold, or sold short are developed. Thus, no consideration is given to any factor other than the specified technical indicators. As we explained earlier in this chapter, this approach to active management is called technical analysis. Because some of these strategies involve the analysis of charts that plot price and/or volume movements, investors who follow a technical analysis approach are sometimes called chartists. The overlying principle of these strategies is to detect changes in the supply of and demand for a stock and capitalize on the expected changes.

Dow Theory

The grandfather of the technical analysis school is Charles Dow. During his tenure as editor of the Wall Street Journal, his editorials theorized about the future direction of the stock market. This body of writing is now referred to as the Dow Theory.¹⁰ This theory rests on two basic assumptions. First, according to Charles Dow, “The averages in their day-to-day fluctuations discount everything known, everything foreseeable, and every condition which can affect the supply of or the demand for corporate securities.” This assumption sounds very much like the efficient market theory. But there’s more. The second basic assumption is that the stock market moves in trends-up and down-over periods of time. According to Charles Dow, it is possible to identify these stock price trends and predict their future movement.

According to the Dow Theory, there are three types of trends or market cycles. The primary trend is the long-term movement in the market. Primary trends are basically four-year trends in the market. From the primary trend, a trend line showing where the market is heading can be derived. The secondary trend represents short-run departures of stock prices from the trend line. The third trend is short-term fluctuations in stock prices. Charles Dow believed that upward movements in the stock market were tempered by fallbacks that lost a portion of the previous gain. A market turn occurred when the upward movement was not greater than the last gain. In assessing whether or not a gain did in fact occur, he suggested examining the comovements in different stock market indexes such as the Dow Jones Industrial Average and the Dow Jones Transportation Average. One of the averages is selected as the primary index and the other as the confirming index. If the primary index reaches a high above its previous high, the increase is expected to continue if it is confirmed by the other index also reaching a high above its previous high.

Simple Filter Rules

The simplest type of technical strategy is to buy and sell on the basis of a predetermined movement in the price of a stock; the rule is basically if the stock increases by a certain percentage, the stock is purchased and held until the price declines by a certain percentage, at which time the stock is sold. The percentage by which the price must change is called the filter. Every investor pursuing this technical strategy decides his or her own filter.

Moving Averages

Some technical analysts make decisions to buy or sell a stock based on the movement of a stock over an extended period of time (for example, 200 days). An average of the price over the time period is computed, and a rule is specified that if the price is greater than some percentage of the average, the stock should be purchased; if the price is less than some percentage of the average, the stock should be sold. The simplest way to calculate the average is to calculate a simple moving average. Assuming that the time period selected by the technical analyst is 200 days, then the average price over the 200 days is determined. A more complex moving average can be calculated by giving greater weight to more recent prices.

Advance/Decline Line

On each trading day, some stocks will increase in price or “advance” from the closing price on the previous trading day, while other stocks will decrease in price or decline from the closing price on the previous trading day. It has been suggested by some market observers that the cumulative number of advances over a certain number of days minus the cumulative number of declines over the same number of days can be used as an indicator of short-term movements in the stock market.

Relative Strength

The relative strength of a stock is measured by the ratio of the stock price to some price index. The ratio indicates the relative movement of the stock to the index. The price index can be the index of the price of stocks in a given industry or a broad-based index of all stocks. If the ratio rises, it is presumed that the stock is in an uptrend relative to the index; if the ratio falls, it is presumed that the stock is in a downtrend relative to the index. Similarly, a relative strength measure can be calculated for an industry group relative to a broad-based index. Relative strength is also referred to as price momentum or price persistence.

Price and Trading Relationship

One popular Wall Street adage is that “It takes volume to make price move.” This suggests a price-volume relationship as a signal for detecting the price movement of a stock used in some technical analyses. The argument put forth by technical analysts is that a rise in both trading volume and price signals investor interest in the stock, and this interest should be sustained. In contrast, a rise in price accompanied by a decline in trading volume signals a subsequent decline in the price of the stock.

Short Interest Ratio

Some technical analysts believe that the ratio of the number of shares sold short relative to the average daily trading volume is a technical signal that is valuable in forecasting the market. This ratio is called the short ratio. However, the economic link between this ratio and stock price movements can be interpreted in two ways. On one hand, some market observers believe that if this ratio is high, this is a signal that the market will advance. The argument is that short sellers will have to eventually cover their short position by buying the stocks they have shorted and, as a result, market prices will increase. On the other hand, there are some market observers who believe this a bearish signal being sent by market participants who have shorted stocks in anticipation of a declining market.

Nonlinear Dynamic Models

Some market observers believe that the patterns of stock price behavior are so complex that simple mathematical models are insufficient for detecting historical price patterns and for forecasting future price movements. Thus, while stock prices may appear to change randomly, there may be a pattern that simple mathematical tools cannot describe. Scientists have developed complex mathematical models for detecting patterns from observations of some phenomenon that appear to be random. Generically, these models are called nonlinear dynamic models because the mathematical equations used to detect any structure in a pattern are nonlinear equations and there is a complex system of such equations.

Nonlinear dynamic models have been suggested for analyzing stock price patterns. There have been several empirical studies that suggest that stock prices exhibit the characteristics of a nonlinear dynamic model. The particular form of nonlinear dynamic model that has been suggested is chaos theory. At this stage, the major insight provided by chaos theory is that stock price movements that may appear to be random may in fact have a structure that can be used to generate abnormal returns. However, the actual application has fallen far short of the mark. Interviews with market players by Sergio Focardi and Caroline Jonas in 1996 found that “chaos theory is conceptually too complex to find much application in finance today.”¹¹

Market Overreaction

To benefit from favorable news or to reduce the adverse effect of unfavorable news, investors must react quickly to new information.¹² Cognitive psychologists have shed some light on how people react to extreme events. In general, people tend to overreact to extreme events. People tend to react more strongly to recent information and they tend to heavily discount older information.

The question is, do investors follow the same pattern? That is, do investors overreact to extreme events? The overreaction hypothesis suggests that when investors react to unanticipated news that will benefit a company’s stock, the price rise will be greater than it should be given that information, resulting in a subsequent decline in the price of the stock. In contrast, the overreaction to unanticipated news that is expected to adversely affect the economic well-being of a company will force the price down too much, followed by a subsequent correction that will increase the price.

If, in fact, the market does overreact, investors may be able to exploit this to realize positive abnormal returns if they can (1) identify an extreme event and (2) determine when the effect of the overreaction has been impounded in the market price and is ready to reverse. Investors who are capable of doing this will pursue the following strategies. When positive news is identified, investors will buy the stock and sell it before the correction to the overreaction. In the case of negative news, investors will short the stock and then buy it back to cover the short position before the correction to the overreaction.

Strategies Based on Fundamental Analysis

As explained earlier, fundamental analysis involves an economic analysis of a firm with respect to earnings growth prospects, ability to meet debt obligations, competitive environment, and the like. We discuss a few of these strategies later where we discuss equity style management.

Proponents of semistrong market efficiency argue that strategies based on fundamental analysis will not produce abnormal returns. The reason is simply that there are many analysts undertaking basically the same sort of analysis, with the same publicly available data, so that the price of the stock reflects all the relevant factors that determine value.

The focus of strategies based on fundamental analysis is on the earnings of a company and the expected change in earnings. In fact, a study by Chugh and Meador found that two of the most important measures used by analysts are short-term and long-term changes in earnings.¹³

In the 1980s, the firm of Stern Stewart developed and trademarked a measure of profitability called economic value added (EVA^®). This measure is the difference between a company’s operating profit and the dollar cost of capital. That is, unlike the conventional method for computing profit which fails to give recognition to the cost of equity capital, EVA deducts this cost. EVA then measures the value added by corporate management to profits after the equity funds that management used in generating operating income is taken into consideration as a cost.¹⁴

Earnings Surprises

Studies have found that it not merely the change in earnings that is important. The reason is that analysts have a consensus forecast of a company’s expected earnings. What might be expected to generate abnormal returns is the extent to which the market’s forecast of future earnings differs from actual earnings that are subsequently announced. The divergence between the forecasted earnings by the market and the actual earnings announced is called an earnings surprise. When the actual earnings exceed the market’s forecast, then this is a positive earnings surprise; a negative earnings surprise arises when the actual earnings are less than the market’s forecast.

There have been numerous studies of earnings surprises. These studies seem to suggest that identifying stocks that may have positive earnings surprises and purchasing them may generate abnormal returns. Of course, the difficulty is identifying such stocks.

Low Price-Earnings Ratio

The legendary Benjamin Graham proposed a classic investment model in 1949 for the “defensive investor”—one without the time, expertise, or temperament for aggressive investment. The model was updated in each subsequent edition of his book, The Intelligent Investor.¹⁵ Some of the basic investment criteria outlined in the 1973 edition are representative of the approach:

1. A company must have paid a dividend in each of the last 20 years.
2. Minimum size of a company is $100 million in annual sales for an industrial company and $50 million for a public utility.
3. Positive earnings must have been achieved in each of the last 10 years.
4. Current price should not be more than 11/2 times the latest book value.
5. Market price should not exceed 15 times the average earnings for the past three years.

Graham considered the P/E ratio as a measure of the price paid for value received. He viewed high P/Es with skepticism and as representing a large premium for difficult-to-forecast future earnings growth. Hence, lower-P/E, higher-quality companies were viewed favorably as having less potential for earnings disappointments and the resulting downward revision in price.

While originally intended for the defensive investor, numerous variations of Graham’s low-P/E approach are currently followed by a number of professional investment advisors.

Market Neutral Long-Short Strategy

An active strategy that seeks to capitalize on the ability of a manager to select stocks is a market neutral long-short strategy. The basic idea of this strategy is as follows. First, using the models described in later chapters, a manager analyzes the expected return of individual stocks within a universe of stocks. Based on this analysis, the manager can classify those stocks as either “high-expected return stocks”or “low-expected return stocks.” A manager could then do one of the following: (1) purchase only high-expected return stocks, (2) short low-expected return stocks, or (3) simultaneously purchase high-expected return stocks and short low-expected return stocks.

The problem with the first two strategies is that general movements in the market can have an adverse affect. For example, suppose a manager selects high-expected return stocks and the market declines. Because of the positive correlation between the return on all stocks and the market, the drop in the market will produce a negative return even though the manager may have indeed been able to identify high-expected return stocks. Similarly, if a manager shorts low-expected return stocks and the market rallies, the portfolio will realize a negative return. This is because a rise in the market means that the manager must likely cover the short position of each stock at a higher price than which a stock was sold.

Let’s look at the third alternative-simultaneously purchasing stocks with high-expected returns and shorting those stocks with low-expected returns. Consider what happens to the long and the short positions when the market in general moves. A drop in the market will hurt the long position but benefit the short position. A market rally will hurt the short position but benefit the long position. Consequently, the long and short positions provide a hedge against each other.

While the long-short position provides a hedge against general market movements, the degree to which one position moves relative to the other is not controlled by simply going long the high-expected return stocks and going short the low-expected return stocks. That is, the two positions do not neutralize the risk against general market movements. However, the long and short positions can be created with a market exposure that neutralizes any market movement. Specifically, long and short positions can be constructed to have the same beta and, as a result, the beta of the collective long-short position is zero. For this reason, this strategy is called a market neutral long-short strategy. If, indeed, a manager is capable of identifying high- and low-expected return stocks, then neutralizing the portfolio against market movements will produce a positive return whether the market rises or falls.

Here is how a market neutral long-short portfolio is created. It begins with a list of stocks that fall into the high-expected return stocks and low-expected return stocks categories. (In fact, we classify this strategy as a fundamental analysis strategy because fundamental analysis is used to identify the stocks that fall into the high- and low-expected return stock categories.) The high-expected return stocks are referred to as “winners” and are candidates to be included in the long portfolio; the low-expected return stocks are referred to as “losers” and are candidates to be included in the short portfolio.

Suppose a client allocates $10 million to a manager to implement a market neutral long-short strategy.¹⁶ Suppose further that the manager (with the approval of the client) uses the $10 million to buy securities on margin. As explained earlier in this chapter, the investor can borrow up to 50% of the market value of the margined securities. This means that the manager has $20 million to invest-$10 million in the long position and $10 million in the short position.

When buying securities on margin, the manager must be prepared for a margin call. Thus, a prudent policy with respect to managing the risk of a margin call is not to invest the entire amount. Instead, a liquidity buffer of about 10% of the equity capital is typically maintained. This amount is invested in high-quality short-term money market instruments. The portion held in these instruments is said to be held in “cash.” In our illustration, since the equity capital is $10 million, $1 million is held in cash, leaving $9 million to be invested in the long position; therefore, $9 is million is shorted. The portfolio then looks as follows: $1 million cash, $9 million long, and $9 million short.

Market Anomaly Strategies

While there are managers who are skeptical about technical analysis and others who are skeptical about fundamental analysis, some managers believe that there are pockets of pricing inefficiency in the stock market. That is, there are some investment strategies that have historically produced statistically significant positive abnormal returns. These market anomalies are referred to as the small-firm effect, the low-price-earnings-ratio effect, the neglected-firm effect, and various calendar effects. There is also a strategy that involves following the trading transactions of the insiders of a company.

Some of these anomalies are a challenge to the semistrong form of pricing efficiency since they use the financial data of a company. This would include the small-firm effect and the low price-earnings effect. The calendar effects are a challenge to the weak form of pricing efficiency. Following insider activities with regard to buying and selling the stock of their company is a challenge to both the weak and strong forms of pricing efficiency. The challenge to the former is that, as will be explained shortly, information on insider activity is publicly available and, in fact, has been suggested as a technical indicator in popular television programs such as “Wall Street Week.” Thus, the question is whether “outsiders” can use information about trading activity by insiders to generate abnormal returns. The challenge to the strong form of pricing efficiency is that insiders are viewed as having special information and therefore they may be able to generate abnormal returns using information acquired from their special relationship with the firm.

Small-Firm Effect

The small-firm effect emerges in several studies that have shown that portfolios of small firms (in terms of total market capitalization) have outperformed the stock market (consisting of both large and small firms). Because of these findings, there has been increased interest in stock market indicators that monitor small-capitalization firms. We will describe this more fully when we discuss equity style management.

Low P/E Effect

Earlier we discussed Benjamin Graham’s strategy for defensive investors based on low price-earnings ratios. The low price-earnings-ratio effect is supported by several studies showing that portfolios consisting of stocks with a low price-earnings ratio have outperformed portfolios consisting of stocks with a high price-earnings ratio. However, there have been studies that found after adjusting for transaction costs necessary to rebalance a portfolio as prices and earnings change over time, the superior performance of portfolios of low-price-earnings-ratio stocks no longer holds. An explanation for the presumably superior performance is that stocks trade at low price-earnings ratios because they are temporarily out of favor with market participants. As fads do change, companies not currently in vogue will rebound at some indeterminate time in the future.

Neglected Firm Effect

Not all firms receive the same degree of attention from security analysts, and one school of thought is that firms that are neglected by security analysts will outperform firms that are the subject of considerable attention. One study has found that an investment strategy based on the level of attention devoted by security analysts to different stocks may lead to positive abnormal returns. This market anomaly is referred to as the neglected firm effect.

Calendar Effects

While some empirical work focuses on selected firms according to some criterion such as market capitalization, price-earnings ratio, or degree of analysts’ attention, the calendar effect looks at the best time to implement strategies. Examples of anomalies are the January effect, month-of-the-year effect, day-of-the-week effect, and holiday effect. It seems from the empirical evidence that there are times when the implementation of a strategy will, on average, provide a superior performance relative to other calendar time periods.

Following Insider Activity

While the SEC has a more comprehensive definition of an insider, we can think of insiders of a corporation as the corporate officers, directors, and holders of large amounts of a company’s common stock. The SEC requires that all trading activity by insiders be reported by the 10th of the month following the trade. The SEC then releases this information in a report called the SEC Insider Transaction Report. Thus, after a time lag, the information is made publicly available. Studies have found that insiders have been able to generate abnormal returns using their privileged position. However, when outsiders use this information, one study found that after controlling for the other anomalies discussed above and transaction costs, outsiders cannot benefit from this information. In other words, insider activity information published by the SEC is not a useful technical indicator for generating abnormal returns.

One of the difficulties with assessing all of the strategies described here is that the factors that are believed to give rise to market anomalies are interrelated. For example, small firms may be those that are not given much attention by security analysts and that trade at a low price-earnings ratio. Even a study of insider activity must carefully separate abnormal profits that may be the result of a market anomaly having nothing to do with insider activity. For example, one study that found no abnormal returns from following insiders also found that if there are any abnormal returns they are due to the size and low price-earnings effects. There have been many attempts to disentangle these effects.¹⁷

Equity Style Management

Several academic studies found that there were categories of stocks that had similar characteristics and performance patterns. Moreover, the returns of these stock categories performed differently than other categories of stocks. That is, the returns of stocks within a category were highly correlated and the returns between categories of stocks were relatively uncorrelated. The first such study was by James Farrell who called these categories of stocks “clusters.”¹⁸ He found that for stocks there were at least four such categories or clusters-growth, cyclical, stable, and energy. In the later half of the 1970s, there were studies that suggested even a simpler categorization by size (as measured by total capitalization) produced different performance patterns.

Practitioners began to view these categories or clusters of stocks with similar performance as a “style” of investing. Some managers, for example, held themselves out as “growth stock managers” and others as “cyclical stock managers.” Using size as a basis for categorizing style, some managers became “large cap” investors while others “small cap” investors. (“Cap” means market capitalization.) Moreover, there was a commonly held belief that a manager could shift “styles” to enhance performance return.

Today, the notion of an equity investment style is widely accepted in the investment community. Next we look at the popular style types and the difficulties of classifying stocks according to style.

Types of Equity Styles

Stocks can be classified by style in many ways. The most common is in terms of one or more measures of “growth” and “value.” Within a growth and value style there is a substyle based on some measure of size. The most plain vanilla classification of styles is as follows: (1) large value, (2) large growth, (3) small value, and (4) small growth.

The motivation for the value/growth style categories can be explained in terms of the most common measure for classifying stocks as growth or value-the price-to-book value per share (P/B) ratio. Earnings growth will increase the book value per share. Assuming no change in the P/B ratio, a stock’s price will increase if earnings grow. A manager who is growth oriented is concerned with earnings growth and seeks those stocks from a universe of stocks that have higher relative earnings growth. The growth manager’s risks are that growth in earnings will not materialize and/or that the P/B ratio will decline.

For a value manager, concern is with the price component rather than with the future earnings growth. Stocks would be classified as value stocks within a universe of stocks if they are viewed as cheap in terms of their P/B ratio. By cheap it is meant that the P/B ratio is low relative to the universe of stocks. The expectation of the manager who follows a value style is that the P/B ratio will return to some normal level and thus even with book value per share constant, the price will rise. The risk is that the P/B ratio will not increase.

Within the value and growth categories there are substyles. In the value category, there are three substyles: low price-to-earnings (P/E) ratio, contrarian, and yield.¹⁹ The low-P/E manager concentrates on companies trading at low prices to their earnings. The P/E ratio can be defined as the current P/E, a normalized P/E, or a discounted future earnings. The contrarian manager looks at the book value of a company and focuses on those companies that are selling at a low valuation relative to book value. The companies that fall into this category are typically depressed cyclical stocks or companies that have little or no current earnings or dividend yields. The expectation is that the stock is on a cyclical rebound or that the company’s earnings will turn around. Both these occurrences are expected to lead to substantial price appreciation. The most conservative value managers are those that focus on companies with above average dividend yields and are expected to be capable of increasing, or at least maintaining, those yields. This style is followed by a manager who is referred to as a yield manager.

Growth managers seek companies with above average growth prospects. In the growth manager style category, there tends to be two major substyles. The first is a growth manager who focuses on high-quality companies with consistent growth. A manager who follows this substyle is referred to as a consistent growth manager. The second growth substyle is followed by an earnings momentum growth manager. In contrast to a growth manager, an earnings momentum growth manager prefers companies with more volatile, above-average growth. Such a manager seeks to buy companies in expectation of an acceleration of earnings.

There are some managers who follow both a growth and value investing style but have a bias (or tilt) in favor of one of the styles. The bias is not sufficiently identifiable to categorize the manager as a solely growth or value manager. Most managers who fall into this hybrid style are described as growth at a price managers or growth at a reasonable price managers (often referred to as “GARP”). These managers look for companies that are forecasted to have above-average growth potential selling at a reasonable value.

Style Classification Systems

Now that we have a general idea of the two main style categories, growth and value, and the further refinement by size, let’s see how an investment manager goes about classifying stocks into the categories. We call the methodology for classifying stocks into style categories a style classification system. Vendors of style indexes have provided direction for developing a style classification system. However, managers often develop their own system.

Developing such a system is not a simple task. To see why, let’s take a simple style classification system where we just categorize stocks into value and growth using one measure, the price-to-book value ratio. The lower the P/B ratio, the more the stock looks like a value stock. The style classification system would then be as follows:

Step 1: Select a universe of stocks.

Step 2: Calculate the total market capitalization of all the stocks in the universe.

Step 3: Calculate the P/B ratio for each stock in the universe.

Step 4: Sort the stocks from the lowest P/B ratio to the highest P/B ratio.

Step 5: Calculate the accumulated market capitalization starting from the lowest P/B ratio stock to the highest P/B ratio stock.

Step 6: Select the lowest P/B stocks up to the point where one-half the total market capitalization computed in Step 2 is found.

Step 7: Classify the stocks found in Step 6 as value stocks.

Step 8: Classify the remaining stocks from the universe as growth stocks.

While this style classification system is simple, it has both theoretical and practical problems. First, from a theoretical point of view, there is very little distinguishing the last stock on the list that is classified as value and the first stock on the list classified as growth. From a practical point of view, the transaction costs are higher for implementing a style using this classification system. The reason is that the classification is at a given point in time based on the prevailing P/B ratio and market capitalizations. At a future date, P/B ratios and market capitalizations change, resulting in a different classification of some of the stocks. This is often the case for those stocks on the border between value and growth that could jump over to the other category. This is sometimes called “style jitter.” As a result, the manager will have to rebalance the portfolio and sell off stocks that are not within the style classification sought.

There are two refinements that have been made to style classification systems in an attempt to overcome these two problems. First, more than one categorization variable has been used in a style classification system. Categorization variables that have been used based on historical and/or expectational data include dividend/price ratio (i.e., dividend yield), cash flow/price ratio (i.e., cash flow yield), return on equity, earnings variability, and earnings growth. As an example of this refinement, consider the style classification system developed by one firm, Frank Russell, for the Frank Russell style indices. The universe of stocks included (either 1,000 for the Russell 1000 index or 2,000 for the Russell 2000 index) were classified as part of their value index or growth index using two categorization variables. The two variables are the P/B ratio and a long-term growth forecast.

The second refinement has been to develop better procedures for making the cut between growth and value. This involves not classifying every stock into one category or the other. Instead, stocks may be classified into three groups: “pure value,” “pure growth,” and “middle-of-the-road” stocks. The three groups would be such that they each had one third of the total market capitalization. The two extreme groups, pure value and pure growth, are not likely to face any significant style jitter. The middle-of-the road stocks are assigned a probability of being value or growth. This style classification system is used by Frank Russell.

Thus far our focus has been on style classification in terms of value and growth. As we noted earlier, sub-style classifications are possible in terms of size. Within a value and growth classification, there can be a model determining large value and small value stocks, and large growth and small growth stocks. The variable most used for classification of size is a company’s market capitalization. To determine large and small, the total market capitalization of all the stocks in the universe considered is first calculated. The cutoff between large and small is the stock that will provide an equal market capitalization to each group.