Buy Side Research Articles

Implementing Basel II standards on the buy side

Implementing Basel II standards on the buy side

When Transactions went High-Tech - A Cross-Sectional Study of Equity Trading Costs in the Light of More Sophisticated Trading Systems

This study aims at comparing the costs of trading at the larger European stock exchanges based on material computed by the Elkins/McSherry consultancy. We will evaluate the evolvement over time, and across exchanges. We find that it's essential to distinguish between the different components of the trading costs. As a consequence, we will break down the total costs into an explicit part and an implicit part, instead of looking at the total levels. The implicit part measures the indirect costs of the trade execution, that being the market impact. Whilst the explicit cost is the amount of fees plus other direct payable costs relating to the trade. Main reason for this is the fact that these components have dissimilar natures and thus different main drivers. Based on figures for the last 8 years we find that the cost levels have varied significantly both over time as well as among exchanges. Derived from both an empirical and a statistical analysis we find that the explicit cost levels have been declining significantly the last years with up to 35 percent. Hence, a drop that has caused the general costs to drop as well. Indications prove that the cost levels among exchanges have been clustering the last couple of years. Further analyses of the cost figures for 2004 indicate that the explicit costs of trading are approximately identical across the major European markets, when adjusting for extraordinary stamp duties on the buy side at the London Stock Exchange. The effect of this recent development leads us to conclude that firstly the levels have clustered around a common mean, and secondly that the general cost levels have declined. When examining the different cost drivers we identify the system turnover as a statistical significant explanatory variable for both the implicit and the explicit cost measure, thus for all three costs measures. A relationship that has not been pointed out in previous work. According to our results, one would expect both the implicit and explicit costs to depreciate as the system activity appreciates. These links serves as evidence of the fact that coalescing trading systems might imply lower future trading costs.

Hype and Algorithms

This article addresses the following key points: By increasing efficiency, algorithmic trading enables traders to focus on difficult orders where they can add value for the firm. Use and customization of algorithms is expected to rise, particularly on the buy side and in Europe. While newer algorithms attempt to mimic human behavior, they cannot replace the judgment and experience of a professional trader. Algorithms have eliminated the order taker role for traders and resulted in a more consultative relationship between the buy side and sell side. Going forward, algorithms must incorporate pre-trade and post-trade analysis to ensure their optimal role in best execution.

Electronic Marketplaces and Price Transparency: Strategy, Information Technology, and Success

Electronic marketplaces (EMPs) are widely assumed to increase price transparency and hence lower product prices. Results of empirical studies have been mixed, with several studies showing that product prices have not decreased and others showing that prices have increased in some cases. One explanation is that sellers prefer not to join EMPs with high price transparency, leading highly price transparent EMPs to fail. Therefore, in order to be successful, EMPs might be expected to avoid high price transparency. But that strategy creates a catch-22 for EMPs on the buy side: Why would buyers want to join EMPs in the absence of price transparency and the benefit of lower prices? We argue that successful EMPs must provide compensatory benefits for sellers in the case of high price transparency and for buyers in the case of low price transparency. To understand how EMPs could succeed, regardless of price transparency, we examined the relationships among EMP strategy, price transparency, and performance by analyzing all 19 EMPs that compete by selling a broad range of standard electronics components. We found that all EMPs pursuing a low cost strategy had high price transparency and performed poorly. All EMPs that performed well pursued strategies of differentiation, but, interestingly, not all successful EMPs avoided price transparency: Some EMPs succeeded despite enabling high price transparency. We therefore examined two differentiated EMPs in greater depth-one with high price transparency, the other with low price transparency-to show how they achieved strategic alignment of activities and resources and provided compensatory benefits for their customers.

The State of the Sell Side

This article addresses the following key points: Sell-side employment levels are at least partially cyclical, and should rebound during the next bull market. The major investment banks will continue to cover large cap stocks. Independent research boutiques will continue to proliferate. The sell side will return to its roots, with more pure research and less marketing. Stock picking will become far more important. The really big money is now on the buy side.

Managing conflicts of interest: U.K. initiatives

The past year has seen a flurry of activity from the major international regulators around issues with a common theme: conflicts of interest. The Financial Services Authority (FSA), the UK regulator, is no exception. On the sell side, the FSA has consulted twice in 2003 directly on conflicts of interest in the context of investment research and the issuance of securities, as well as making new rules in this area. On the buy side, the FSA shocked the fund management industry with its proposals to limit goods and services that can be bought with commissions and to limit the costs to customers’ funds of acquiring bundled and “softed” services, as well as less explicitly attempting to address conflicts in this area. The issues thrown up by these proposals are considered in this article.

Easing the Tension Between the Two Sides

This article addresses the following key points: Understanding expectations on both sides is the first step toward fostering a positive relationship. The buy side should actively shape the flow of information from the sell side. The sell side must find a way to guarantee its independence and objectivity. The buy side must recognize that certain conflicts are built into the structure of the sell side, and adjust for them.

Analyst Recommendations and Nasdaq Market Making Activity

I investigate the linkage between liquidity provision by Nasdaq market makers and analysts in the same firm. Using three measures of market activity, I find that Nasdaq firms are more likely to provide buy side liquidity in anticipation of upgrades in the period 1999-2000. ECN activity supports this pattern. Firm level evidence shows that 15 of 42 market makers studied engage in significant pre-recommendation activity. I estimate cumulative abnormal returns of more than 75% and profits of almost $600 million in a sample of 47 large capitalization stocks.

The Chartered Alternative Investment Analyst Program

The CAIA Association is sponsored by the Alternative Investment Management Association (AIMA) and the Center for International Securities and Derivatives Markets (CISDM)—two organizations providing global leadership for alternative investment professionals by setting the highest standards in alternative investment education, professional conduct, and advocacy programs. The CAIA program is designed to promote and maintain professional standards for those employed or engaged in the alternative investments industry. The program facilitates both personal and professional development through education and certification. A goal of the CAIA program is to become the standard professional credential in the field of alternative investments and to have the CAIA designation serve as an independent and external validation of competence for all participants in alternative investment markets. The designation appeals broadly to hedge fund managers, managed futures advisors, real estate, private equity, and venture capital managers, institutional investors, and other professionals in the area of alternative investments. Like many charter programs in finance and accounting, the CAIA designation is structured as long-distance education and requires candidates to accumulate a level of knowledge necessary to implement various aspects of alternative investment decision-making, both from the buy side and from the sell side. This level of knowledge includes, but is not limited to, asset allocation among traditional and alternative investments, benchmarking, manager, strategy, and asset selection, and legal and qualitative differences between different alternative investment strategies and structures. In order to obtain the CAIA designation a candidate must pass both levels of CAIA exams, hold a bachelor’s or an equivalent degree, fulfill the CAIA Association membership requirements, and apply concurrently for membership in the CAIA Association. The Web Review

The Evolution of E-Trading in Fixed-Income Markets

Bond has evolved from a purely voice trading (telephone-based) system through a spectrum of electronic mechanisms (from single-dealer systems to multidealer hubs to single-log-in multidealer platforms) to its current state—on the verge of another evolution to a fully automated exchange. And although the drivers of e-trading growth are pushing the market toward that end, significant dampers on progress exist. Regardless of the future form that e-trading assumes, market structure will continue to change. Adopting new approaches for inventory management, protocol development, and straight-through processing will be necessary. Perhaps the most important factor affecting the future viability of e-trading is the attitude of market participants, particularly on the buy side.

What We Think About the Quality of Our Equity Markets

Have the technological and regulatory changes in the U.S. equity markets in recent years improved or impaired market quality? As “market quality” is an ambiguous concept that is neither readily quantifiable nor amenable to straightforward empirical analysis, the authors have surveyed the opinions of sell–side and buy–side participants and academic financial economists. Academic respondents in general, and the microstructure subset in particular, are relatively positive about market quality and the efficacy of regulatory initiatives. The predominant response on both the sell–side and the buy–side is that the quality of the U.S. equity markets has deteriorated in recent years. Technology is broadly thought to be a great tool, but many industry participants believe that market structure regulation is not helping.

Fair Values, Comprehensive Income Reporting, and Bank Analysts' Risk and Valuation Judgments

We investigate whether the measurement and reporting of comprehensive income in financial statements systematically affects commercial bank equity analysts' investment risk assessments and valuation judgments. In an experiment in which 80 buy side analysts specializing in banking and financial institutions participated, we vary whether a bank is exposed to or hedged against interest rate risk across three different comprehensive income accounting regimes - piecemeal fair value accounting with comprehensive income reported in the statement of changes in equity, piecemeal fair value accounting with comprehensive income reported in a separate statement of performance, and full fair value accounting with comprehensive income reported in a separate statement of performance. When fair value changes are measured and reported on a piecemeal basis, we find no investment risk or valuation judgment differences across CI reporting regimes. Although we find that the analysts' investment risk judgments are influenced by the banks' risk management strategies, their valuation judgments are not. Only when fair value changes are measured completely and reported transparently (i.e., full fair value accounting) do analysts' valuation judgments distinguish between banks with different levels of risk. The study contributes to three avenues of literature concerned with financial-reporting transparency, risk, and fair value accounting. First, our ex ante evidence informs accounting standard setters as they evaluate whether to move to full fair value accounting for all financial instruments, and assess the degree to which differences in comprehensive income measurement and reporting affect the information analysts obtain from financial statements. Second, the study adds to the experimental accounting literature that examines comprehensive income reporting format effects and valuation judgments. Third, we add to archival accounting research on the information in comprehensive income by testing market participants' judgments under different comprehensive income reporting regimes, which cannot be directly investigated with archival data.

Five-Factor Theory of Personality

Funding for municipal infrastructure projects in Europe, Asia, and Latin America has traditionally been provided by intermediaries such as governmental lenders, commercial banks, and multilateral regional banks. As governments become more and more hard-pressed to pay for projects, however, new attention is being paid to capital market debt issues based on stand-alone credits similar to U.S. municipal revenue bonds. Now both the buy side and the sell side of the capital markets are motors propelling development of the revenue bond market abroad. Full development will take several years, even in Western Europe, but there are key credit issues to be aware of now.

Bubble Logic: Or, How to Learn to Stop Worrying and Love the Bull

A bull market, and the incentives of those who make their living from bull markets, can create its own form of logic. This book explores some of the stories that encourage the purchase or retention of stocks or mutual funds and the logic behind these stories. Some of these stories are honest attempts to explain new phenomenon, and may or may not prove true going forward. Some seem to be unintended falsehoods that come from an incomplete or lazy application of economic reasoning. Finally, some seem less well intended. The stories, and the logical analyses behind them, generally originate with Wall Street (both sell side and buy side), sometimes riding the coattails of academia, and are often readily absorbed by investors engaged in wishful thinking. Such wishful thinking has led to a stock market, and the growth/tech sector of the market in particular, that is priced so expensively that even very long-term investors will probably end up disappointed, perhaps greatly so.

Large price movements and short-lived changes in spreads, volume, and selling pressure

In this paper we examine changes in dollar and relative bid-ask spreads of stocks following large price movements. We investigate large increases and decreases separately and link our results to current market microstructure theories on trading activities and spreads. We also look at changes in volume and selling pressure to interpret the changes in trading activity. Our results show that the market reacts differently to price increases and decreases. For large price decreases, trading increases on the sell side even when spreads have increased. For large price increases, trading increases on the buy side during a period of higher spreads. However, the increases in dollar spreads and price pressure are most pronounced at the end of trading day. Our results are consistent with microstructure models that link trading activities and costs to the level of asymmetric information.

Institutional Investor Activism and Financial Market Structure

This article investigates investor activism when a number of investors are capable of expending resources to exercise a role in corporate governance rather than the single large monitoring shareholder featured in most of the extant literature. Managers choose a level of perk consumption based on their conjectures regarding investor monitoring strategies. Institutional investors make monitoring decisions and engage in strategic trade in anonymous financial markets with other agents whose trades are motivated either by liquidity or by portfolio- balancing considerations. In this setting, it is shown that a core group of monitoring institutions emerges endogenously to curtail managerial opportunism. These core institutions pursue activist policies and engage in heavy trading on both the buy and sell side of the market. In addition a fringe group of monitoring institutions, which are somewhat active and trade only on the buy side, may emerge. Although the smallest institutions are passive, there is no monotonic relationship between shareholdings and activism. In fact, among those institutions that choose to monitor with positive probability, those with smaller holdings are the most active. In addition to characterizing the emergence of monitoring activity in the presence of numerous potential activist investors, comparative statics are also developed. Some these comparative statics are counterintuitive from the perspective of models that fail to endogenize both security market structure and shareholder activism: For example, it is shown that, despite the attendant exacerbation of the free-rider problem, some dispersion of institutional holdings can actually increase monitoring efficiency, and that increasing the size of the shareholdings controlled by informed institutional investors may lower bid-ask spreads.

Odd Lotter Trading of High and Low Quality Stocks

THANKS LARGELY to the New York Stock Exchange Public Transactions Studies' and the pioneering efforts of Charles 0. Hardy2 and Garfield Drew,3 there is certain amount of information available about how odd lot investors behave as group. Generally speaking we know they favor high quality stocks, prefer buying to selling, prefer to hold stocks for the long run, avoid margin, and could be lot better in their timing. While considerable information has been generated concerning the aggregate buying and selling proclivities of the odd lotter, there is comparatively little known of his behavior concerning individual stocks. Since October, 1964, data on purchase and sales of 75, and more recently, 100 common stock sample have been made available by the Securities Exchange Commission,4 thereby permitting examination of odd lotter trading in individual securities. Garfield Drew's odd lot studies suggest that, in the aggregate odd lotters buy more than they sell when prices are low and sell more than they buy when prices are high. To the extent that this is true, they demonstrate what we can call a search for -a buying of what seems to them to be undervalued and selling of what seems to them to be overvalued stocks. At the very extremes of price variation, the odd lotter apparently yields increasingly to the temptation to switch from value and seek performance by increasing his relative buying at the tops and selling at the bottoms. Drew emphasizes, however, that this is relative phenomenon. While the ratios of selling to buying decline just before market tops, they nevertheless do remain on the sell side. Similarly, at the bottoms, while the ratios rise somewhat, they nevertheless remain on the buy side. At the turns, the odd lotter is on the correct side of the market, although to lesser degree than he might have been.5 But these are aggregate data that are compared to indexes of aggregate prices. Do they describe how the odd lotter behaves with regard to all sorts of individual securities, or are they characteristic only of the over all averages? With regard to lesser quality securities we might anticipate that odd lotter behavior would be different. Investors buying and selling these stocks at all would tend to be more risk oriented than those trading in the blue chips. Given the assumption of different people, or at least different motivations for trading in these securities it is logical extension to hypothesize different behavior. One might anticipate more emphasis on performance and less on value. A speculative vehicle that is bought for shorter term capital gains might well be bought when prices are high in anticipation of them going higher with money derived from the sale of stocks that are low and expected to go lower.