Pennying not cause of higher trade cost

By Wayne H. Wagner and Mark Edwards

A recent magazine article states in the subtitle that "Blue chips now cost more to trade on the Big Board than small caps do," noting this runs counter to the conventional wisdom that "large, actively traded stocks have lower transaction costs than smaller, less liquid ones."

The author provides a table that shows "microcap" stocks (less than $250 million capitalization) costing 0.5 cents per share on the NYSE, while "giant cap" stocks (capitalizations in excess of $25 billion) cost 1.9 cents per share.

The article attributes this phenomenon in part to pennying; "... NYSE specialists' and floor brokers' putative practice of bidding a stock up or down by 1 cent and trading for their own accounts ahead of investors."

That finding is false. And it is dangerous: It might lead to misidentification of the magnitude, source and relevance of transaction costs and thus contribute to inferior performance.

We will develop three important points:

-- Using pennies-per-share as the metric ignores the fact that small-cap stocks trade at lower prices than large-cap stocks. When expressed in economic terms as percentage of principal, this key finding is simply false: liquid, large-cap stocks trade at no higher impact cost than smaller stocks.

-- The actual costs of implementing investment ideas is in fact significantly higher than the figures quoted in the article. True implementation costs are egregious and much larger than can be seen through the narrow perspective of the volume-weighted average price, or VWAP, comparison.

-- The damning of specialists and floor brokers on the basis of this evidence is faulty logic based on faulty measurement.

Cents per share sounds like a simple metric, but it only works if the share prices are reasonably similar. For example, a penny cost on a $100 stock is 0.1%; on a $10 stock it represents 1.0%. That's a big difference.

In today's markets, the average traded share price for NYSE-listed stocks with capitalization less than $250 million is about $7; for stocks in excess of $25 billion, the average price is around $35. Table 1, shown below, adjusts VWAP impact for stock price, and shows a relationship with company size that is largely in line with the expectation that large, liquid stocks should be easier to trade than smaller-cap stocks.

VWAP defines impact as the difference between the average price in the trade being executed and the average price in the market. Note that the VWAP impact figures do not net to zero, as they would do if the game were one that pitted institutional buyers against institutional sellers. The investors must be losing to someone else, specifically specialists, market makers, hedge funds and speculators, who enter the market opportunistically solely to garner short-term trading profits. In the process, they provide liquidity to investors.

Institutional traders enter the market to implement investment decisions. They cannot be opportunistic traders. Therefore, investors pay speculators for the provision of liquidity, leading to frictional costs in the range of 5 cents per $100 traded (five basis points).

A more inclusive alternative to the VWAP measure is called implementation shortfall. It measures the change in price from the starting gate, where the trader receives the order, to the finish line, when the entire trade is completed. It answers the question: How much of the potential return did I lose to the cost of implementing the trades?

The costs in Table 2 atop this page show figures for all buy and sell trades for a sample of 89 investment managers during the second quarter of 2003. The picture here is one of impact as a percent of traded dollars rising as market cap falls.

The last column provides a partial explanation of trade size effects: the average trade in the largest cap group is almost 19 times the size in the microcap group. Other things being equal, we expect large trades to cost more than small trades.

Things are not equal, however, since large-cap stocks are far more liquid and therefore easier to trade. Thus the interplay of trade size and available liquidity determines the trading cost. Differences in liquidity are ignored by the VWAP benchmark, which uses the same benchmark irrespective of trade size.

But there are hidden costs of trading beyond the impact.

First there's the commission. Looking at NYSE commission costs by capitalization group shows the cents-per-share commissions are fairly steady.

Another hidden cost of trading is the cost of searching for liquidity, which occurs because institutional orders are often too large to be simply presented to the market. Liquidity search costs are real; they eat into the research advantage for stock purchases, and they cost real dollars on security sales when prices decline before finding the liquidity to complete the trade.

When measured from the starting-gate price, the search costs easily dwarf the impact and commission costs. They also show the expected relationship: smaller-cap stocks are more expensive to trade.

Note that search costs are much higher for the microcap stocks because the search for liquidity is often long. In fact, the trading in these stocks is described as "by appointment."

Adding together the commission, impact and search cost components shows total cost, and Table 3 shows the relationships are as we expect: small-cap stocks are more costly to trade when measured in economic terms as percent of principal.

In cents per share, costs peak in the midcap range, but this is an artifact of the share price falling faster than the costs are rising down the rows of the table.

The VWAP — repeated from the first table — ignores the hidden search costs and understates the real costs of trading. It also reverses the cost to capitalization relationship. VWAP has its uses, but analyzing trade cost data is notoriously tricky. When the conclusion doesn't match the intuition, one needs to be extra careful.

Now we turn to the assertion that the apparent — but non-existent — extra cost for large-cap trades comes from pennying by the specialists. The estimates we have seen for the cost of pennying are in the $150 million range. The NYSE Fact Book for 2002 quotes a dollar volume of $10.278 trillion.

We double that figure to account for the fact that there is a buyer and a seller for every share sold. The figure comes to 0.0007 basis points or two hundredths of a cent on an average $26 share. This amounts to roughly 2% of the VWAP cost and is not large enough to account for the (misidentified) difference in cost. Given the current sensitivity concerning specialist behavior, the offhand attribution of effect to pennying strikes us as careless and inflammatory.

In summary, the key to successful trading is to manage the speed of execution. Trade too fast and your demands for liquidity will allow others to profit from your urgency. Trade too slow and the information edge you are trying to capture might be discovered by others, wiping out your advantage. Thus traders need to weigh the impact costs of urgently executed orders against the search costs of more passive trading techniques. VWAP, which measures only impact, looks at only one side of the coin.

Wayne H. Wagner is chairman, and Mark Edwards, vice president, of Plexus Group Inc., Los Angeles.