Tag Archives: kurt-dew

Market Evolution And The Demise Of Good-Til-Canceled And Stop-Loss Orders

Summary There have been articles in SA recently touting common stocks of some major exchange management firms. These are not stocks for your retired aunt who taught grade school. They are stocks for your cousin who runs a surfing equipment shop on Maui when she’s not on tour. Exchange management is a high tech business where a winner can become a loser in a matter of months. Decisions like NYSE, NASDAQ and BATS’ prohibition of good-‘til cancel orders, beginning in February, show that exchange management is crisis management. This is Part 1, the introduction, of a discussion of winners and losers among the corporations that manage exchange trading, including CBOE Holdings (NASDAQ: CBOE ), the CME Group (NASDAQ: CME ), the Intercontinental Exchange (NYSE: ICE ), NASDAQ Inc. (NASDAQ: NDAQ ), and London Stock Exchange Group, for example]. These articles will analyze “What’s in?”, “What’s out?”, and “Who Knows?” This first article sets the table for those that follow. What’s in? The future of processing securities and futures transactions is very bright, as the cost of entering, clearing, and communicating results of transactions goes to zero and execution approaches warp speed. The future of banking is in making big investment decisions, finding the right financing, the right companies on the investment execution side, and advising investors about participation in the enterprises they sponsor. Some exchange is going to remember that serving the needs of legions of small investors is profitable. That exchange will find a way to create an environment where these traders are not constantly swamped by high speed traders and institutions. What’s out? Places where we see men in brightly colored jackets announcing new issues and ringing a quaint bell at the market open, like the building on the corner of Broad and Wall Street. They are museums and retirement villages – glorified photo ops. Financial institutions as a storehouse for securities and other claims on real wealth. One day soon this will be done globally by a computer the size of your fingernail. Financial institutions as trading intermediaries. That business is low margin, high volume, and independent of strategic economic and financial forecasting issues. Forget foreign exchange, deposit trading, and derivatives trading by banks. Financial institutions will advise users and do the trade that originates the use of these instruments by corporations and investors, but the billions of follow-on trades are soon to be non-bank activities. Exchange corporations that make too many decisions like the one made by Intercontinental Exchange ( ICE ), the owner of the NYSE], the other day, to end GTC and SL. Unless NYSE has more changes in mind than simply those, that was a bad decision. Good exchange decisions will attract traders; bad decisions, repel them. This decision will repel many traders. Who Knows? The future of the thing that we now call an exchange, defined as a localized collection of computer servers that confirm trade execution, like the NYSE now, is in some doubt. The future of the collection of companies listed in the first paragraph above is uncertain. If they depend on markets functioning as they do today, they are zombies. If they see themselves as electronic tech companies, in a race to find the fastest, most secure, means of placing, executing, clearing and communicating transactions, they have a shot at being the king of the world of transactions. There is likely to be only one in the end. And it may be none of the firms listed above, but one of the dark pools that wait to usurp these firms’ dominant position. Or a company that does not yet exist. It will be fun to watch (from an investment-free position.) This series of articles is a warning to investors in these exchange management companies: To forecast the fortunes of the firms above, forget the charts. Forget b and a. Forget forecasts of trends in income, the size of income margins, and the like. These firms are the wildcat oil drillers of finance. They exhibit handsome returns in the past few years. (And wages are high for deep sea divers, if they survive and surface to collect.) As a combined portfolio of shares, the sort of analysis that applies to Google, now Alphabet, Inc., ( GOOGL , GOOG ) or Apple (AAPL] is relevant for these stocks. The future of electronic trading and clearing in the next several years is good. But keep a close eye on new players. Also old players, such as dealers like Goldman Sachs (NYSE: GS ) and the hedge fund, Citadel, that have an unexplained interest in trading technology. But the individual corporations are not so secure. Some of them may not be with us in as few as five years. The changing technology of trading and the jockeying of the combatants are as much fun to watch as a Star Wars battle scene. If your money is not invested in one of the losers. As an aside, here is a list of dark horses: Bank of New York Mellon (NYSE: BK ), State Street Corp. (NYSEARCA: SST ), BATS Exchange, and IEX. My guess is that the ultimate king of the hill will be someone we have not mentioned. It’s human nature. Darwin knew about it. Change in the environment always means the death of old species and the rise of new species. So to resist change is instinctive. It promotes species survival. The human animal hates change. NYSE management hates change. Individual investors hate change. Following articles will expand on the reasons for my picks of winners and losers.

Index ETF Investors Are Vulnerable To A Return To Rational Pricing

Recent financial research suggests that inclusion of a corporate share in an index ETF adds to its market value. As index ETF investor participation grows, overpricing apparently becomes more pronounced. As ETF participation has become a greater share of the investment universe, these effects have apparently become more important. As a result index ETFs may now be both less diversified and overvalued. A return of shares included by ETFs to their fundamental, rationally determined, values would adversely impact an index ETF investment. The effect of the new valuations on index ETF decision-making would be perverse, leading to further investor losses. According to much recent financial research, the market’s focus on index ETFs [such as the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), the iShares Core S&P 500 ETF (NYSEARCA: IVV ) and the Vanguard Total Stock Market ETF (NYSEARCA: VTI )] has led to overpricing of many of the common shares included in the important indexes, accompanied by underpricing of companies excluded by the indexes, among other pricing anomalies. This mispricing presents a hazard to investors. The only existing investor defense against a return of these overpriced stocks to their rational value is to buy underpriced stocks outside the index ETF with properties similar to the overpriced stocks inside the ETF. How can the simple publication of an index number intended to represent the value of the stock market as a whole change the value of common stocks? The indexes that are the subject of this article are the source of the dominant common stock investment strategy of the moment, the index ETF. For example the Standard and Poors 500 Stock Index (S&P, a value-weighted average of the 500 largest common shares listed on the NYSE or NASDAQ) is the oldest and still the most important example of a traded numerical characterization of the value of the equity market as a whole. Index exchange traded funds (ETFs) are exchange-listed instruments that replicate broad market measures such as the S&P. Index ETFs are big – about 30% of the volume of all investment funds under management. But there may be strange effects of the existence of index ETFs on the prices of stocks that are part of an index. Those effects, or at least the current scholarly take on them, is chronicled in an interesting October 10th article in the New York Times . The Times article points to substantial evidence produced by market researchers that common stocks included in the popular listed indexes are often, by all the usual measures, overvalued relative to similar stocks outside the indexes. In the current financial academic literature, this is a prominent example of market irrationality. It is not rational, the argument goes, for the simple inclusion of a stock in an index portfolio to change investor behavior and thus affect market prices of securities so profoundly. But the evidence points to several effects. It has been clear, almost since the S&P 500 index began to be published, that being newly included in an important index increases a stock’s market value; while a fall into exclusion leads to a decline in market value. But there is evidence of other more profound effects as well. It appears that as a greater share of the market is included in index portfolios, the effects of index inclusion on stock prices have become more pronounced. And the effects may not simply be higher prices of stocks within the indexes, but higher correlations among the prices of stocks within the indexes as well. This higher correlation is particularly interesting, since it has investor risk management implications. If higher past correlation continues, the major indexes no longer perform their function in portfolio theory – risk reduction through diversification. Why? If correlation between investments inside the indexes rises, correlation among instruments outside the indexes rises, and correlation between index-included and index-excluded investments falls, a diversified portfolio must include stocks outside the index. In other words, the behavior of stocks in index ETFs creates a paradox. The effect of index ETF growth is that the index no longer represents a diversified portfolio. Index ETFs are, in this sense, self-defeating. To form a truly diversified portfolio, investors must now add other stocks outside the ETF. The index ETFs are vulnerable to any trading strategy that exploits this mispricing. One trading strategy that a hedge fund might apply to restore rational pricing to the stock market has characteristics that can be found in my SA Instablog: ” A Trading Strategy Based on Index ETF Overpricing. An ETF Defense. ” Investors can protect themselves (imperfectly) now from a return to rational pricing of the shares included by the index ETFs, and simultaneously achieve the portfolio diversification index ETFs once provided, by buying diversified shares outside the ETFs.