buttonwood ii

CFA Institute

Buttonwood IIAuthor(s): Wayne H. WagnerSource: Financial Analysts Journal, Vol. 44, No. 2 (Mar. - Apr., 1988), pp. 8-12+28Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4479097 .

Accessed: 14/06/2014 17:33

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.

http://www.jstor.org

This content downloaded from 185.2.32.89 on Sat, 14 Jun 2014 17:33:22 PMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=cfa

http://www.jstor.org/stable/4479097?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


Guest Speaker

Buttonwood II

by Wayne H. Wagner Partner/Chief Investment Officer Plexus Group

In 1792, the founders of the New York Stock Exchange began to meet under the buttonwood tree at what is now 68 Wall Street in lower Manhattan for the purpose of exchanging securities. We can presume that it was awkward and expensive to express trading interests in the eighteenth century. How could a captain from New Bedford hope to find the Virginia farmer who was look- ing for the security he had to sell? It was a necessity to hire someone to act as agent.

Obviously, the system worked- and worked well. The commission was reasonable, and the system got the job done: People were able to trade securities, and entrepreneurs got access to capital to build their ventures and to collect their rewards. Over time, the system became even more convenient, as the agents became mid- dlemen, taking positions between the times buyers and sellers arrived. Be- cause order arrival was sporadic, the capital provided by this "specialist" function was a tremendous advance.

In order to trade, however, the in- vestor had to divulge his identity and the nature of his trade before he could trade: The broker was privilege to who was about to trade, and the exchange in turn knew what was about to trade. In other words, a trader had to enfran- chise the exchange community with a gift of enormous value-the knowledge of who was willing to trade and under what terms. Over time, a tradition developed whereby this knowledge was (and is) regularly and systematically divulged to individuals and organizations to whom this information is the stock-in-trade of their highly profitable business.

Today, nearly 200 years later, the system retains the same basic form,

and it still works well. Traders world- wide continue to send most of their orders to trade under the spreading branches of the NYSE. And the fran- chise is probably more valuable than ever: Consider what an advantage it is to know the ideas and intentions of large, aggressive institutional investors.

Changing the Exchange How many other systems of com- merce can boast two centuries of solid tradition in the face of constant change, change, change? This one has survived and prospered because we all accept that it gets the job done in a satisfactory way.

The NYSE, along with peripheral markets, has evolved to provide the facilities that traders as a group want and demand. Similarly, it has mini- mized the things traders want to avoid. It has taken its "degrees of freedom" in areas the users consider irrelevant; its costs are assessed in areas traders consider least important.

Why are market orders used? Be- cause traders want them! Why do program trades exist? Because they satisfy a need! Why isn't it cheaper to trade? Because traders have been satisfied with the present costs. Given the in- tensity of competition, and the robust capacity for change evident in the current structures, it seems likely that the desired facilities are available at the lowest cost possible. To argue other- wise is to embrace a "conspiracy" the- ory, one that would be difficult to justify on theoretical or practical economic grounds.

We have the market we deserve: It exists in its current form because it is the best solution to the trading prob- lem as presented. Yet it is not the only possible solution. Other markets operate differently, and still others could be created by the institution of new processes. If a broad enough spectrum

of users believed that these new processes offered worthwhile advantages, a constituency for new trading solu- tions would be created.

Now consider the following facts.

* In this age of specialization, most trades now occur between a few hundred fiduciaries. One can count either the owners of the assets or their hired managers, and still come up with a few hundred entities. They could easily all fit on the floor of the exchange and act for their own interests. * These fiduciaries command far more capital than the whole specialist system, or even the whole of Wall Street. They really don't need the capital of the exchange community they are accustomed to relying upon to finance their trading. * These fiduciaries are so large they can, and in many cases do, make their own markets. The largest equity managers boast that they can han- dle as much as 60 per cent of their trading within their own client base, in-house. * Communication of information is efficient, cheap and instantaneous, with computers handling most ac- counting of funds and most trans- fers, often without benefit of human hands. Most "money" exists in the form of electrical impulses spinning around on disks. * The Department of Labor is pressing ERISA plan fiduciaries to recog- nize trading costs as an expense of the plan.

Fiduciaries are becoming increasingly suspicious of the tendency of their managers in aggregate to underper- form the market by substantial amounts. According to the data of the Trust Universe Comparison Service, only 38 per cent of professional managers measured beat the S&P 500 over the five-year period ending December

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 O 8



31, 1986.1 The average shortfall was approximately 1 per cent. According to the performance data gathered by SEI Corporation, eight of 10 managers underperformed the market index over a 15-year period.2

Where does the performance go? Could the exchange process be something other than a zero-sum game as far as the beneficial owners are con- cerned? Is secrecy and liquidity something used partially against as well as for the interests of the owners?

The 1986 NYSE Fact Book reports that members earned commission in- come of $8.249 billion and "trading and investment profits" of $10.987 billion.3 These figures (especially the trading and investment profits) include elements besides equity profits, but when added together and divided by the total value of dollars traded, they imply a 1.98 per cent transaction cost. This, when allocated to the two sides of the trade, comes close to the size of the manager shortfall.

The message increasingly heard from plan fiduciaries is that trading costs are too high.4 This implies that certain market participants may be willing to forgo some currently supplied trading benefits in favor of devel- oping a market mechanism that stresses other benefits-namely, lower cost.

If the demand exists, can the market mechanism be altered in such a way as to reduce the cost of trading? The place to start is with a determination of where the costs lie in trading. We hypothesize the critical cost factors in the current market to be the following, listed in order of increasing impor- tance:

* labor costs, * indirect (bundled) costs, * risk-assumption costs and * information loss.

The only effective way to reduce costs is for sponsors and their managers to (1) attempt to minimize information loss and (2) bear directly more of the labor, indirect and risk-assumption costs. The challenge is to design an exchange mechanism that accom- plishes these cost-saving goals.

Labor Costs Labor costs are high because key elements of the trading process are currently delegated to highly compensated Wall Street traders using expensive facilities in the traditional manner. A portfolio manager's decision to buy or sell a security triggers a labor-intensive sequence of telephone calls, trade tick- ets, market intelligence gathering, price negotiations, confirmations and settling trades.

There is little doubt that Wall Street has traditionally attracted talented and highly motivated individuals. They are highly compensated, both in direct compensation and in privileged access to vital information. To do their job, they are supported by an extensive array of facilities. Upstairs trading rooms, for example, are supported by some of the largest communication and data systems available.

Once an order gets to the floor, however, securities still trade as though the fastest message was still sent by horse! In an age when mes- sages travel at 186,000 miles per second, orders (other than DOT orders) are still walked from the place where the client is contacted to the stump where the trade occurs. Just when a trader most wants to provide control, guidance and instructions, his agent is physically out of touch. We trust that the agent is acting in the client's best interests, but it is unsettling to have no control over last-second decisions and adjustments. We seem to pay dearly for the traditional shoe leather on the floor of the exchange.

One key to lowering labor costs is to replace expensive person-to-person communications with less costly electronic access. At the same time, direct electronic access avoids expensive miscommunications that lead to costly trading mistakes and clearing fail- ures.5

Indirect Costs Transaction costs buy more than just execution. By "paying up" for trans- acting, investment managers also re- ceive research and other "soft dollar" benefits at no extra charge. The superb security and economic research available through the brokerage industry would be very expensive for the man-

agers to create or acquire by themselves. Indeed, it is critical to most active managers. Even quantitative managers access analytic power and data from the brokerage community.

Managers may well be reluctant to sacrifice these benefits in exchange for reduced commissions, even though transaction costs may represent a substantial handicap to investment performance. In fact, pressure from these managers modified ERISA to permit continuation of soft-dollar practices.

The Department of Labor, however, looks askance at the practice, insisting that transaction cost dollars represent an expenditure of fiduciary trust assets.6 The DOL is pressing for an ac- counting of where these trust assets are spent, and some justification that they are being spent wisely in the interests of beneficiaries.

From the sponsor's view, this part of the cost of professional investment management is invisible and frequently confused with transaction costs. If transaction costs are to be lowered, this bundling of research services must be brought above-board. Invest- ment management fees may have to rise to cover the additional cost of research paid for in cash by the investment managers. If past experience with unbundling in other industries is any indication, the sum of the pay- ments for the parts will be less than the bundled payment for the whole.

Risk-Assumption Cost Risk-assumption costs occur when managers demand that a broker assume the risk as buyer-of-last-resort in order to complete a trade. As the ad- vertisement of a major block house proudly and appropriately proclaims, they "Take Risks and Commit Capi- tal." Risks here include individual company risk, market risk and trading supply/demand risk-factors that move stock prices before the broker can relieve himself of the position. In effect, the broker sells the manager an option on the stock, as the broker guarantees execution at a specific time and price. As is true of any option, the risk is proportional to the time of exposure and represents the cost of "liquidity."

Liquidity is commonly thought of as 1. Footnotes appear at end of article.




the willingness of the broker to assume the position-for a price-until the natural other side arrives. In the final analysis, however, the only real source of liquidity is the natural inves- tor ultimately on the other side of the trade. Without the contra side of the trade, the broker's limited capital would quickly be tied up, and his ability to provide bridge liquidity would disappear.

Risk-assumption costs arise from a desire to trade immediately, without waiting for natural liquidity on the other side. To the extent that this demand for liquidity arises from un- awareness or lethargy, it can be avoid- ed. If risk is proportional to time of exposure, however, costs can be reduced by increasing simultaneity. How that might work is illustrated by the following analogy.

Suppose a person insisted on instant liquidity every time he traveled by air: At whatever moment he decid- ed to travel, the necessary equipment and crew would be ready to respond instantly. This would clearly be expensive, not only because of the high cost of transporting one person alone, but also because of the expenses incurred to keep equipment and personnel on "standby.'" That is the effect of instant liquidity: Substantial resources must be available on standby for whenever they are called upon, and they must be paid for while idle, as well as when in use.

Most of us don't demand instant liquidity in air transport; we go to Kennedy Airport at 6:00 pm to catch American Airlines #21 to Los Angeles. In air transportation, liquidity is gathered together by establishing a specific departure time; travelers agree to wait for the scheduled opportunity to travel, because it is significantly cheaper than demanding instant service.

Securities markets could work similarly, by gathering liquidity in a "call- to-market" trading environment. The expensive facilities required to provide instant liquidity would not be chosen unless absolutely needed. Perhaps it would not be quite as convenient as the current system, but those willing to bear the inconvenience could econ- omize on the cost.

A call-to-market system is in com-

mon use even now. Any auction, such as the Treasury bill auction, is a call-to- market. Secondary distributions represent an explicit call-to-market. Many foreign exchanges operate at least partially on a call-to-market basis. Even the establishment of the opening price on the floor of the NYSE is a call-to- market.

While a call-to-market environment would seem to pose little inconvenience to passive and quantitative managers, some active managers might worry that they would be un- able to execute their decisions instantly. Doesn't information arrive in real time, they would argue, and doesn't the price series reveal costly information as it is acted upon?

To a certain extent, most institutional investment decisions result from a contemplative processing of gathered information, rather than from instant reaction to news items. Perhaps a call- to-market system would create prob- lems for managers who apply techni- cal intraday timing methods or use close-to-the-source information, but these managers are atypical of institutional investors.

Is it possible that the value of instant liquidity is overestimated?

If a broker knows where the natural other side can be found, he may give the appearance of bearing risk, when little or no risk truly exists. (Remem- ber, true liquidity exists only when the broker can quickly lay off his positions.) Suppose a manager receives a "hot tip" and uses a principal trade to unload stock. The broker will assured- ly discount his bid to reflect his assessment of the manager's information. (In all probability, the broker is already a better informed adversary and knows as much or more than the manager; at minimum, he knows more than the manager about the desires of other traders.) He will also intuitively factor the probable holding time into his bid.

If the tip is true, the manager "wins" at the expense of the supplier of natural liquidity, whoever ends up on the other side of the trade. Yet few traders think of themselves as suffer- ing an information disadvantage in most trading situations. The broker wants both sides of the trade to believe

they were treated fairly. If the other side is another institution with whom the broker maintains an ongoing rela- tionship, he is unlikely to "bag" this other valued customer (at least not too frequently). Nor is a passive trader a sitting duck; we know that index funds track the indexes, as promised, which means that they cannot be sys- tematic losers in the trading game. It is doubtful, based on the performance records, that institutional investors systematically win at the expense of the investing public.

So is the value of instant liquidity real or illusionary? If instant liquidity is not as valuable as commonly perceived, it is little more than a mere convenience, masquerading as a sub- stantive benefit and achieved at a higher-than-justifiable price.

But consider the environment of an institutional trader: The portfolio manager's investment decisions are obviat- ed if the trader fails to execute. Failing to complete the trade is a no-win prop- osition for the trader: He can use his skills to do the best he can, but the thought pattern within which he operates places the highest value on com- pletion-i.e., liquidity. In this process, the brokerage community is his strongest ally, and the exchange community has cleverly laid strong foun- dations by building up and reinforcing the perceived need for its services. The interests of the sponsor (who has been told that he is not competent to inter- fere with the professional managers' investment decisions) may be considered at best only peripherally in this self-reinforcing trading process.

Information Loss Information loss occurs when the fact that someone wishes to trade is revealed without compensation in the process of trying to find liquidity on the other side, either through principal or agency trading.

Other than accepting a risk-assumption cost, as outlined above, there are only two ways to find the other side of a trade-advertising or responding to the advertising of another. The advertising may be done directly or through a broker. This is true for almost all current trading mechanisms.

Market orders, secondary offerings

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 0] 10



and sunshine trades initiate advertising. Participate orders respond to advertising. Best-efforts trades, fourth- market trades, limit orders and third- market orders either initiate advertising or respond to advertising. Market-on-close orders, principal trades and program trades advertise or go through a facilitator. A few types of trades-such as inventory fund trades and in-house, informationless "per- fect" crosses-can be executed without involving advertising. All other trading techniques involve some exposure of trading willingness prior to execution. The amount of exposure may vary, but the majority of trades are not executable until after at least one side has revealed intent. If the trade goes through a broker, both sides may telegraph their intentions, possibly to the detriment of both.

There are no effective prohibitions against the broker or the exchange using this information for its own account, acting in its own interest. In fact, the use of this information is sanctioned; by implicit agreement, this privileged information compensates the broker/specialist for conducting markets in the preferred manner.

The bottom line is that, as markets currently operate, traders must perform destructive testing to assess the market for a potential trade. After the test has been performed, the advantage of exclusive knowledge of intention is lost. The traders have tipped their hands to some part of the exchange community. How strange it would seem to a manufacturer to give his competition advance notice of his product intentions!

Why do traders accept this? In truth, they have little choice. Current markets work this way because that's the way traders have decreed they want them to work. Few have seen any need for a system that operates in true and complete secrecy. Liquidity is the revealed preference.

Who wants it to work this way? The exchange community is privy to valuable information concerning who is willing to trade what, when and at what price. The investment manager passes off much of the expense of running an investment operation to the brokers. These costs are then

passed without direct accountability to the beneficial owners and sponsors through commission costs and trading impact.

Who is going to ring the bell on this triumph of hope over experience? Only the sponsor or the beneficial owner, whose money it is anyway. Only sponsors can create a market of new priorities, a market that stresses low execution cost and holds managers accountable for the effects of transaction costs.

Many sponsors are reluctant to in- terfere with the decision/execution process of their managers. Indirectly, however, the pressure for incentive fees is designed to encourage managers to consider how productively they utilize client assets.7 The experience to date is that managers, left to their own devices, are often either unconcerned or defensive about transaction costs. Perhaps managers have become over- ly dependent on the brokerage community for services that improve the economics of the investment management business.

Below, we illustrate a market that is organized to emphasize low cost, yet provides sufficient liquidity without players having to reveal their intention to trade.

A Call-to-Market Exchange: Features and Benefits A "call-to-market" exchange central- izes liquidity by specifying a time that trades will take place. All parties wish- ing to trade under the terms of the call meet in one place at one time to trade whatever volume crosses under mutually acceptable terms.

This suggests a direct electronic call market for stocks that applies the cheap and accurate system we have for communication of information right to the point of exchange. Spon- sors and their fiduciaries could represent their own interests, without the intervention of facilitators. It might require waiting the few minutes or hours or days for natural liquidity to occur, but after all, aren't sponsors usually trading among themselves anyway? If sponsors as a group benefit, any given sponsor must expect to benefit.

A call-to-market exchange accepts

good orders up until the time of the match; those securities that pair off become executions; those that do not are canceled and can trade at the next call or through other means.

A call-to-market exchange requires that the participants (the sponsors and their fiduciaries) bear (make instead of buy) more of the direct labor costs of securities exchange. It requires that they pay their managers fees adequate to cover cash payment for the required research services. It also requires that they wait for liquidity (for departure time), and thus bear risk to avoid paying a facilitator to assume the risk. Finally, they avoid information leakage; it is not necessary to divulge the nature of intended trades, except to a totally neutral and totally secret "black box."

Price Discovery in Call-to-Market Exchanges But wait .. . aren't we forgetting something important? Isn't the key function of the market to set prices? How does a call-to-market exchange provide that function without reveal- ing the side/size of the imbalance?

Before we address the issue of price discovery, it is important to realize that most orders do not affect price in any market, including the current one. Consider the actions of a specialist as he opens the book in the morning. If the volume of buy orders approxi- mates the volume of sell orders, the market should open unchanged. In any market, a small amount of trading sets the price; most of the rest is mere- ly ticking off. A cross, a natural meet- ing of liquidity, does not change the price.

Like any market, a call market needs a price discovery mechanism, a means of determining the price at which supply and demand are balanced. That function is provided by a market maker and/or the use of limit orders.

Who is a market maker? Basically, anyone who is willing to buy at one price and sell at a higher price. It doesn't have to be someone who is anointed to perform the function. It could, for example, be any of the very large index funds, with an inventory of billions of dollars in literally thou- sands of stocks. Wouldn't their clients




be pleased to put that passive inventory into action to pick up a little liquidity-provision profit? Or consider the massive pension funds: They could offer to buy and sell securities from their vast holdings. Like stock lending, it'-s a more productive use of the assets that lie there anyway; it represents latent earning power.

The point is, anyone can be a market maker. In economic terms, anyone who stands ready to trade, for whatever motivation, is a market maker while trading that stock.

The easiest way to make a market is with a pyramid of limit orders. The more anxious the other party is to trade, the more stock the accommoda- tor is willing to accept, provided the price is right. By printing the executions, all parties would know that the price has moved, driven by an excess of supply or demand. The print, however, does not reveal information about what has not yet traded; there is no predictive information in a done trade.

What if the liquidity is not there? What happens to a trader with a massive position to trade? Does he have to wait interminably to complete his trade?

Not necessarily. He could conduct a sale, announcing his willingness to trade, like a secondary distribution or a so-called "sunshine" trade. This would encourage the other side of the trade to meet him at his time schedule at a mutually acceptable price. The interesting feature of a totally revealed, announced trade is surprising- ly similar to that of a totally secret trading mechanism: There is no information advantage granted to any party. Only selective information divul- gence leads to information leakage.

Summary We have created the market we deserve. Those exchange functions that traders want are provided at a cost considered fair-or at the least at a cost that has become more or less traditional-and create a need for facilitators who are handsomely rewarded for their efforts. The single most important function demanded is liquidity, and investors are historically will-

ing to pay what it takes to get it. In order to make this type of market function, however, trading intent must be revealed; unfortunately, the current market does not and cannot remain neutral once trading interest has been revealed.

The term "market maker" could hardly be more appropriate: When liquidity is demanded as the primary focus, markets must be made, the time gaps between arrival of traders bridged by either the liquidity provided by the market maker or the ability of the market maker to ferret out the other side of the trade. This service does not come free.

But liquidity is not the only possible goal of an exchange system. Low-cost trading could be the focal point. Changing the focal point implies changing the system, and changing the system can result only from changes in motivation. Current market participants show little interest in changing the system; only the sponsors, the beneficial owners, can induce change. This will occur only if sponsors (a) want a change and (b) demand a change.

One alternative to a continuous market that emphasizes liquidity and requires a well-compensated exchange community to provide it is an automat- ed, secret, neutral call-to-market exchange. Such a market will allow lower trading costs because of higher efficiency, cen- tralization of supply/demand in time as well as in location, and reduction of information leakage concerning trading intentions. Table I summarizes the differences between the two systems.

Many developments suggest that sponsors desire changes in the current system. These developments include:

* the resounding acceptance of low- cost passive management; * pressure for lower commission costs and interest in trade monitor- ing; * pressure for accountability of managers in the form of incentive fees; and * legal pressure to account for transaction dollars as fiducial assets.

If corporate sponsors addressed transaction costs and other pension

issues in the same manner they ap- proach direct-line business issues, what questions would they be likely to ask?

* Shall the sponsor make or buy investment strategies? * How can the desired investment result be produced at less cost? * What is desired from managers and brokers as they operate as sup- pliers of services to the pension plan? * How can managers and brokers be motivated to provide the nature and quality of services demanded at a fair price? * Without compromising the duty to beneficiaries, how can the cost of providing desired pension benefits be reduced? * Without compromising the duty to beneficiaries, how can the risk to the corporation from this line of business be reduced? * How can pension activities be subjected to the same discipline as the other demands on corporate cash flow?

If a low-transaction-cost system is demanded, it will be created. The flexi- bility, the spirit of service and accom- modation that started at the Buttonwood tree, will provide the new facilities that market participants demand-and at the lowest cost.8

Table I Current Exchange vs. Call-to- Market Exchange

Liquidity-Oriented Cost-Oriented Exchange Exchange

Liquidity supplied Liquidity supplied by by broker/exchange sponsor/manager

On demand Time-centralized

Trading information Trading information leakage neutrality

Labor intensive Electronic

Bundled costs Direct assessment of costs

Provides features Provides features demanded by demanded by managers sponsors/owners

Footnotes appear on page 28.

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 12



Returns" (Working Paper No. 1629-84, Sloan School, M.I.T., 1984); K. R. French, "Stock Re- turns and the Weekend Effect," Journal of Finan- cial Economics 8 (1980), pp. 55-69; M.R. Gibbons and P. Hess, "Day of the Week Effects and Asset Retums," Journal of Business 54 (1981), pp. 579- 596; and L. Harris, "A Transaction Data Study of Weekly and Intradaily Patterns in Stock Re- turns," Journal of Financial Economics 16 (1986), pp. 99-117.

4. For this research, William O'Neil + Co. provided me with a specially formatted computer tape containing the information on NYSE and AMEX firms from the Datagraph books. This is the first time William O'Neil + Co. has made these pro- prietary data available for an academic study.

5. O'Neil personnel employed criteria other than just price appreciation to choose firms. However, such criteria are not explicitly stated. Based on the University of Chicago's CRSP tapes, there are 4,049 occurrences of a NYSE or AMEX firm doubling in value within a given calendar year during the 1970-83 period. For example, one additional criterion seemingly applied to stocks by O'Neil personnel is related to the price per share of a stock. In O'Neil's universe of 272 firms, fewer than 5 per cent sold at a price less than $10 a share. Of the list of 4,049 firms that doubled, if one eliminated those selling for less than $10, the number would dwindle to 1,311 companies. Giv- en the customer base subscribing to this publica- tion, such a price level screen is not all that surprising. Furthermore, it does not bias this analysis. At worst it might caution one against applying the findings from this research to stocks selling for less than $10.

6. These categories are strictly the author's and are not part of the O'Neil data.

7. Upon request, the author will provide similar

data for the banks, mutual funds and insurance companies.

8. See J.F. Jaffe, "Special Information and Insider Trading," Journal of Business 47 (1974), pp. 410- 428 and H. N. Seyhun, "Insiders' Profits, Costs of Trading, and Market Efficiency," Journal of Financial Economics, June 1986, pp. 189-212.

9. See Basu, "The Investment Performance of Com- mon Stocks," op. cit. and Reinganum, "Misspeci- fication of Capital Asset Pricing," op. cit.

10. See M. R. Reinganum, "The Anomalous Stock Market Behavior of Small Firms in January: Em- pirical Tests for Tax-Los Selling Effects," Journal of Financial Economics, June 1983, pp. 89-104.

11. Betas were calculated using ordinary-least- squares regressions and weekly returns during the two-year period prior to the buy date. The proxy for the market portfolio is a value-weight- ed index of all NYSE and AMEX companies.

12. One cannot rule out the possibility that O'Neil personnel implicitly (it is not stated in the publi- cation) applied some of these criteria to define a great winner. For example, given their institutional customers, it might make commercial sense for them to exclude most companies selling at a price less than $10 or whose market capital- izations are smaller than $20 million.

13. To the extent that the samples of 222 winners and other firms are correlated, some subtle biases may remain. Application of the trading strategies in other time periods should eliminate any re- maining biases.

14. See K.C. Chan and N-F. Chen, "Estimation Error of Stock Betas and The Role of Firm Size as an Instrumental Variable for Risk" (CRSP Working Paper No. 179, University of Chicago, 1986).

15. See Reinganum, "Anomalous Stock Market Be- havior," op. cit.

Guest Speaker footnotes, from page 12.

Footnotes 1. The Trust Universe Comparison

Service is a cooperative performance comparison service operated by Wilshire Associates, Santa Mon- ica.

2. Funds Evaluation Report (New York: SEI Corporation, 1987).

3. New York Stock Exchange, 1986. 4. Trading costs include commissions,

market impact, market-maker spreads, clearing costs-the total

(but untraceable) difference between what the buyer pays and what the seller receives.

5. Labor costs are also high because of errors and complications in the clearing process, but that is not the subject of this paper.

6. Remarks by Morton Klevan, Depu- ty Administrator, Office of Pension and Welfare Benefits, Department of Labor, at the Institutional Inves-

tor Conference, January 1987, New York.

7. R. Grinold and A. Rudd, "Incentive Fees: Who Wins? Who Loses?" Fi- nancial Analysts Journal, January/ February 1987.

8. The author wishes to thank Edward Story of Plexus Group and William Lupien and Tibor Fabian of Instinet Corporation for their many helpful comments and suggestions.




buttonwood ii

Documents