Institutional investors exonerate NASDAQ of charges of collusion and price-fixing, but have plenty of other gripes.
And they increasingly are avoiding the network of securities dealers.
The Justice Department's antitrust division said Oct. 19 it was investigating the dealers who make NASDAQ markets to see if there is price-fixing in what investors are charged when they buy and sell NASDAQ stocks.
But many institutional investors say the wider spreads between the bid and asked prices on smaller stocks traded on the over-the-counter market are more a function of the system's makeup than some conspiracy.
Yet investors are not happy with illiquidity, lack of transparency and what they say are growing ethical lapses.
The chance of collusion is "plausible with respect to retail investors. But it's hard to imagine how we would ever have been hurt. Part of the allegation is that institutions are treated better. But institutional investors trade in larger lots, and it stands to reason they would pay a smaller rate of transaction costs," said Rex Sinquefield, chief investment officer at Dimensional Fund Advisors, Santa Monica, Calif., which runs nearly $6 billion, mostly in small-capitalization stocks.
Collusion? "It's probably overhyped. In any business, people talk to each other," said Michael Murphy, senior director of Morgan Grenfell Capital Management Inc., New York, which runs $700 million in small-cap stocks.
"While there undoubtedly are some abuses, we don't subscribe to a conspiracy theory to explain the cost differentials," said an Oct. 25 report by Wayne Wagner and Mark Edwards of Plexus Group, Santa Monica, Calif., a trading consulting firm to institutional investors.
Alternative systems popular
Nevertheless, big institutions continue to shift a greater proportion of their trading to crossing networks and other alternative trading systems in order to cut trading costs.
The College Retirement Equities Fund trades 75% of its $36 billion in quantitative equities through alternative trading systems. Because the benchmark is the Russell 3000, most of the stocks are small-cap.
Investors Research Corp., Kansas City, Mo., the investment adviser to the Twentieth Century family of mutual funds, was one of the early firms to sign on to Instinet, one of the alternative trading systems. By year end, it will have traded more than 200 million shares on Instinet, a significant percentage of that in small-cap stocks. It also uses other alternative trading systems.
Aronson + Fogler trades 90% of its $1 billion in stocks across the board on alternative trading systems. Unlike other portfolio managers interviewed, Theodore Aronson, a partner with the Philadelphia firm, said unequivocally that NASDAQ has "collusion without a doubt. The bummer is it's tacit collusion. It's as difficult to punish in the securities market as in the automobile market."
Some 85 institutions - including CREF, Twentieth Century, Aronson + Fogler, Fidelity Investments, State Street Bank & Trust Co. and the Shell Oil Co. pension fund - and 30 brokers will be using the latest new wrinkle on crossing networks, the Chicago Match, a new institutional crossing system of the Chicago Stock Exchange. A competitor of POSIT, another crossing network, it will be trading 100 OTC stocks in three weeks. Trading is in decimals, rather than 32nds. It matches trades once a day in the morning and charges significantly lower commissions when trading is not done anonymously, according to Roger Hendrick, vice president-institutional marketing. By contrast, Instinet doesn't allow undisclosed trades.
"If the dealer market is still being used as it was intended, then why are brokers choosing to use so many alternative systems?" asked Harold F. Bradley, vice president and director of equity trading of Investors Research Corp.
"The dealers' operative assumption is that the investor always wants immediate liquidity," the Plexus report said. "But the exploding use of alternative systems shows that investors would rather wait to complete a trade in order to get a better price."
At Investors Research, "we have found that in the last four years, on average, the business we do on Instinet is the lowest capitalization and highest volume, yet the transaction costs as measured by SEI are less than average for the house - 50 to 150 basis points cheaper," Mr. Bradley said.
"Obviously, we'd like to see smaller spreads but I'm not sure what the best way to get that is. I'm not sure it can be regulated," said Eric Fisher, vice president of TIAA-CREF, New York. "More competition typically lowers spreads.
Reducing the market impact costs of trades and reducing commissions were the motivations - not any concerns about improprieties of the NASDAQ system.
"We were among the original people on POSIT and Instinet," as well as the Arizona Stock Exchange, a single-price auction trading system, Mr. Fisher said.
Mr. Bradley said the use of alternatives reflects the growing discontent on the part of institutional investors with NASDAQ.
"Obviously there's concern with spreads, with liquidity and with ethics," said Morgan Grenfell's Mr. Murphy.
Transparency and ethics
On the ethics side, he said dealers increasingly are disclosing the names of institutions making trades to other parties. "It never used to happen, and most institutions are distressed to see it happening," Mr. Murphy said, adding it happens more frequently on NASDAQ than on the New York Stock Exchange.
Another issue is proprietary trading by brokers. "If I'm selling, maybe he's selling stock with me - or he wants to be short in the stock," Mr. Murphy said.
Others also said greater transparency is needed.
Keith Ambachtsheer, principal of KPA Advisory Services, Toronto, said the public should see what the "book" for a stock looks like: the price, the number of shares trading, and not only the high and low quotes but the limit orders behind them, to "get a sense of the full interest in a given stock."
One portfolio manager for a large insurance company who asked not to be identified said he doesn't always get reports of trades across the screen in a timely fashion. "You have to actively pursue getting a report on your order. .*.*. It doesn't bother me," but it forces investors to trust their brokers.
"In addition to commissions, the broker might be getting paid to funnel trades to a particular market maker," he added.
But the portfolio manager noted "having wide spreads doesn't mean activity doesn't take place inside the spread, especially in active stocks."
(On Instinet, all trades are inside the spread, at the midpoint between the bid and asked prices.)
"The system needs retuning on a continual basis," Mr. Murphy said. He suggested NASDAQ establish a committee to oversee dealers in a manner similar to the NYSE's committee that oversees the specialist system.
Scott Black, president of Delphi Management Inc., Boston, which runs $650 million, more than half in OTC stocks, said: "I think the NASDAQ market is pretty fair. Most of the time I'm able to trade for an eighth of a point. With very small and lower priced stocks, I might be able to do it for one-sixteenth of a point. They're transparent - honest," he said. He noted that right after the trade, the investor can see what the book looked like on the stock.
Echoed Frank Minman, chief investment officer of Equitable Asset Management, Nashville, Tenn., which runs $30 million in small-cap stocks: "I'm usually able to trade in the middle of the spread."
The strategy of many portfolio managers is to concentrate order flow with a few brokers to develop a good relationship so that "they're willing to work for an eighth of a point," Mr. Black said. By contrast, "an individual doesn't have the clout and can't bargain," he said.
DFA has an unusual strategy; it acts as a buyer of last resort. "We generally don't incur positive trading costs. We're trading under the bid," Mr. Sinquefield said.
"We wait for brokers to come to us with natural sellers of large blocks (not brokers selling for their own account). Our portfolio structure allows us to demand that people pay us for liquidity."
The 100,000-share-per-trade blocks in which DFA deals are too large for NASDAQ market makers. The firm runs nearly $6 billion, mostly in small-cap stocks, and has an unusually large trading and portfolio staff for a passive manager.
"We're prepared to take down the entire block if we get it on our terms," he said. The firm uses crossing networks only to sell stocks.
Government investigation
The Justice Department inquiry appears to stem from civil suits filed after an academic study raised the possibility of collusion among market makers to keep spreads wide, a charge the National Association of Securities Dealers flatly denies.
"This is beautiful. Now the evidence is just slapping everybody across the face," said Mr. Aronson.
But Plexus executives disagreed that price-fixing is involved. Instead, they think the differences in trading small-cap stocks stem from illiquidity, structural weaknesses in the NASDAQ system and "adverse information effects." In other words, a dealer loses something like half of the spread to knowledgeable traders so he sets a spread that covers his costs plus his information disadvantage.
Of course, competition limits the extent of the spread. This problem is "probably less severe with the institutional trades," the report said.
"The difference is 'the relationship.' Continuing to serve as a trusted intermediary to a big institution is far more important to a dealer than a once-and-maybe-never-again retail trade," the report said.
Unlike on exchanges, where a trader can execute trades ahead of dealer/specialist orders, on NASDAQ a trader is virtually forced to trade with a dealer. A trader cannot put in a limit trade, bid against the dealer or outbid the dealer to be the first to complete an order, the Plexus report said.
"If all the dealers are offering to sell for $10, the investor should be able to offer 101/8 to secure a place at the front of the line," the Plexus report argued.
On the NASDAQ system, if dealer A ends up long a stock and dealer B is short, there is no easy way for them to offset the positions to reduce risk. Thus, the investor pays the price through higher spreads. Because there is no commission on NASDAQ trades, Plexus suggests dealers charge a servicing fee for placing a limit order or arranging a crossing trade.
Mr. Ambachtsheer believes NASDAQ should move to a system resembling the Toronto Stock Exchange, a hybrid of auction and electronic markets.
Mr. Sinquefield said unless the Justice Department is able to prove wrongdoing, he hopes no changes will be made in the OTC market.
