Trading Stocks Without the Chatty Cathys

It's common knowledge that mutual fund shareholders lost money in the late-trading and market-timing shenanigans that have recently consumed the fund industry. But shareholders have been losing many times more money over a longer period of time due to something more insidious inefficient trading. Large fund companies can't buy and sell securities without incurring a market impact. As soon as word

It's common knowledge that mutual fund shareholders lost money in the late-trading and market-timing shenanigans that have recently consumed the fund industry. But shareholders have been losing many times more money over a longer period of time due to something more insidious — inefficient trading.

Large fund companies can't buy and sell securities without incurring a market impact. As soon as word gets out that a big mutual fund is a buyer of a particular stock, third parties in search of quick profits are trying to get in first and in turn, driving up the price of the shares.

According to the Plexus Group, a Los Angeles-based researcher that studies trading, market-impact costs are 0.73 percent for trading large-cap stocks and 1.28 percent for small-cap securities. In other words, a fund manager must pay 0.73 percent more for a large company stock by the time the order is executed. The reason? Large orders are frequently broken up among many brokers and specialists, meaning a lot of people know a big fund's intentions.

“There is so much information leakage out there, what our positions are, whether we're buying or selling a particular stock,” says John Wheeler, head of trading at American Century funds in Kansas City, Mo. Wheeler estimates that American Century, with $92 billion in assets, loses close to $100 million a year because of this.

Now, managers have an alternative: Mutual fund managers are increasingly moving to electronic trading platforms like Liquidnet and ITG's Posit, which bring together buyers and sellers anonymously in an effort to remove the “Chatty Cathy” intermediaries. Three-year-old Liquidnet now serves 80 percent of the mutual fund universe, despite the fact that its system can only satisfy less than a quarter of the stocks institutional investors want to trade.

“The economics in this industry have been seriously reversed,” says Seth Merrin, CEO of New York-based Liquidnet. “The institutional investors have simply grown so large that every time they go to make a trade, they move the market. They've outgrown the market structure's ability to trade efficiently.”

According to Liquidnet, funds could improve their performance by three percentage points a year — including index funds — if trading inefficiencies could be cleared up. (Index funds incur lower trading costs, but that's because they trade less frequently than actively managed funds.)

The new exchanges bring buyers and sellers together to negotiate directly inside a black box. For example, if a fund company has 100,000 shares of Ford to unload and another fund outfit is looking for a 300,000 block of that stock, each party can put their information into Liquidnet's system, but without disclosing the quantities. They negotiate a price and only then are the number of shares disclosed.

Posit is slightly different. Both parties input their info into the system, which matches buyers and sellers 15 times during the day without direct interaction.

“The information is only leaked to people who do not have an interest in using it against you,” Wheeler says. Half of American Century's trades now pass through an alternative trading platform.

In addition to the exchanges' arcane structure, fund trading costs are also higher for funds that have soft-dollar arrangements with brokerages. With soft-dollar deals, mutual funds direct trades to certain brokerages in exchange for research or even tangible goods like computer terminals. Those brokers may not always get the best price execution, which translates into worse fund performance.

“If a lot of inefficiencies were worked out, it would be easier for funds to do their trades faster and with more certainty,” says Ari Burstein, associate counsel with the Investment Company Institute. “That could bring costs down for the funds and get passed down to shareholders.”

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