The Trading Process and Mutual Funds

1
The Trading Process and Mutual Funds
B, K M Chapters 3 4
End of chapter problems (3) 2,3,7 (4) 1,2,10,17
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Primary Markets How Firms Issue Securities

• The primary market is used to issue new
  securities (IPOs) or seasoned new issues
• There is strong evidence of underpricing of new
  equity issues both here and abroad
• The secondary market is used to trade
  outstanding securities

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How Firms Issue Securities

• Investment Banking
• Shelf Registration
• Private Placements
• Initial Public Offerings (IPOs)

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Shelf Registrations

• Introduced in 1982
• SEC Rule 415
• Opposed by Investment Banks
• Ready to be issued on the shelf

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Private Placements

• Private placement sale to a limited
• number of sophisticated investors not
• requiring the protection of registration
• Allowed under Rule 144A
• Dominated by institutions
• Very active market for debt securities
• Not active for stock offerings

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Initial Public Offerings

• Process
• Road shows
• Bookbuilding
• Underpricing
• Post sale returns
• Cost to the issuing firm

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Relationship Among a Firm Issuing Securities, the
Underwriters and the Public
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Figure 3.3 Average Initial Returns for IPOs in
Various Countries
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Long-term Relative Performance of Initial Public
Offerings
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Secondary Market Trading Mechanisms

• Dealer markets (OTC markets)
• Electronic communication networks (ECNs)
• Specialist markets
• Auction Markets

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Types of Retail Orders

• Market Orders buy or sell orders that are
  executed immediately at current market prices
• Limit Orders specify prices at which an
  investor is willing to transact. Example IBM
  last sold for 50. A limit may be placed at a
  price of 45. If the price falls to 45, this
  order will then be executed.
• Stop-Loss Orders similar to limit orders but
  they specify the trade is not to be executed
  unless the price hits a limit. (In the previous
  example, a stop buy order might be placed at a
  price of 55.)

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Limit Order Book for Intel on ArcaEx Exchange
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U.S. Security Markets

• Nasdaq Stock Market
• Nasdaq National Market System (min shareholder
  equity 15mil)
• Nasdaq SmallCap Market (min shareholder equity
  5mil)
• Pink Sheets (www.pinksheets.com)
• Even smaller firms or those that want to avoid
  listing disclosure requirements
• Organized Exchanges
• New York Stock Exchange
• American Stock Exchange
• Regionals
• Electronic Communication Networks (ECNs)

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Table 3.1 Partial Requirements for Listing on
Nasdaq Markets
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Nasdaq Market Center

• Nasdaq Market Center
• Consolidates electronic markets into an
  integrated system
• Allows for automatic execution
• Levels of subscribers
• Level 1 inside quotes
• Level 2 receives all quotes but they cant
  enter quotes
• Level 3 dealers making markets

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Trading on the Nasdaq Market

• Competing dealers establish bids and asks
• It is increasingly a computerized market with no
  centralized location
• The Department of Justice settled a suit against
  NASD that alleged price fixing by dealers in the
  establishment of quotes
• Academic studies (Christie and Schultz, 1995)
  detailed apparent tacit collusion, and lead to
  the Department of Justice and SECs actions

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New York Stock Exchange

• The Major Players
• Commission brokers
• Bring a brokerage firms orders to the floor for
  execution
• Specialists
• Block houses
• SuperDot
• NYSE members send orders directly to the
  specialist over computer lines

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Some Initial Listing Requirements for the NYSE
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NYSE

• On the NYSE, each stock traded has a specialist
  who is charged with maintaining a fair and
  orderly market

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Block Transactions on the New York Stock Exchange
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Electronic Computer Networks (ECNs)
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Market Structures in Other Countries

• London - predominately electronic trading
• Euronext market formed by combination of the
  Paris, Amsterdam and Brussels exchanges
• Tokyo Stock Exchange

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Dollar Volume of Trading in Major World Markets,
2004
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Trading Costs
Explicit Costs Commission costs which are paid
to brokers are explicit (full service vs
discount brokers)
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Bid-Ask Spreads

• Bid is the highest limit order to buy
• Ask is the lowest limit order to sell
• Dollar Spread Ask Bid
• Proportional Spread (Ask Bid) / (Mid-Point
  of Spread)
• Proportional spreads range from well less than
  1 to over 5 (over 10 for penny stocks)
• Equally weighted average proportional spread on
  NYSE stocks is .6
• Nasdaq spreads are higher

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Determinants of the spread
Spreads depend on -the amount of competition
between providers of liquidity -the need to
cover the costs of being a dealer including
-inventory costs -and the possibility that the
dealer (specialist) will trade with a better
informed trader
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Buying on Margin

• The investor borrows part of the purchase price
  from the broker
• The Fed dictates the maximum margin (currently
  50) meaning that at most 50 of the purchase
  price may be borrowed
• By buying on margin, investors gain leverage and
  greater upside potential, but also expose
  themselves to greater risk
• If the stock price falls, the investor may
  receive a margin call

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Short Sales

• First borrow certificates for sale (from
  broker), then repay the loan with certificates
  obtained in a later purchase
• Must be identified as a short sale (may not be
  made in a falling market tick test on NYSE
• Borrower must deposit cash equal to the initial
  value of the securities, and post additional
  margin
• Borrower must pay the lender the equivalent of
  all dividends or interest received between the
  short sale and the subsequent repurchase
• Potential loss of short sale is unlimited

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Short Sales (cont.)

• In 2003 short sales accounted for approx. 10 of
  total sales (NYSE specialists and hedge funds are
  frequent short-sellers)
• Short interest is the total of all shares sold
  short that remain uncovered (reported in the WSJ)

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Mutual Funds

• Benefits to individual investors include
• - Efficient record keeping
• Low-cost diversification
• Professional Management
• Lowered transaction costs
• Open-end funds stand ready to redeem or issue
  shares at their net asset value (NAV) which is
  the market value of all securities held divided
  by the number of shares outstanding. The number
  of shares will change daily
• Closed-end funds are traded much like shares of
  common stock. They do not issue or redeem shares
  at NAV, and often trade at a discount or surplus
  NAV (have lost much market share to ETFs)
• Often sell at a premium or discount from NAV

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Mutual Funds (cont.)

• Real Estate Investment Trusts (REITs) Similar
  to a closed-end fund invested in real estate
• Hedge Funds Structured as private partnerships
  and subject to little SEC regulation
• Exchange Trades Funds Typically replicate an
  index but trade like individual stocks
• Unit Investment Trusts Pools of money invested
  in a portfolio that is fixed for the life of the
  fund
• ---Have declined in importance

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U.S. Mutual Funds by Investment Classification,
December 2004
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Mutual Fund Costs

• Front-end load A commission paid when you
  purchase shares. Range from 0 to as much as 10
• Back-end load A redemption fee paid when you
  sell shares. Often declines as a function of how
  long the shares have been held
• Operating Expenses The costs of operating the
  portfolio, including fee paid to investment
  advisors and administrative expenses. Low for
  index funds (for specialized funds
• Are periodically deducted from the funds assets
• Operating expenses are an important determinant
  of fund performance!!

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Mutual Fund Costs (cont.)

• 12b-1 Charges These fees are named after the
  SEC rule that permits funds to pay for
  distribution costs such as advertising,
  promotional literature and, most importantly,
  commissions to brokers out of fund assets
• Are deducted from the funds assets
• Fees can have an important impact on fund
  performance

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Mutual Fund Costs (cont)

• Many Fund Families Offer Different Classes of
  Shares (Dreyfus Premier Growth Fund as of 2003)
• Class A Class B Class C Class T
• Front-end Load 0-5.75 0 0
  0-4.5
• Back-end Load 0 0-4 0-1 0
• 12b-1 fees .25 1 1 .50
• Expense Ratio 1.25 1.25 1.25 1.25

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Very Important Advice

• Never buy a fund with a front-end load, 12b-1
  fees, or an expense ratio above .5 (1 for an
  international fund)
• If there is a back-end load, it should go away
  with time

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Mutual Fund Performance
Do mutual fund managers, on average, beat the
market? This is an important question we will
take up in detail when we discuss market
efficiency.
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ETFs (Exchange Traded Funds)

• Trade like individual stocks, but typically
  replicate an index
• Low expenses and tax efficient
• Can be bought on margin and sold short
• Purchasing (and selling involves incurring the
  same transactions costs associated with
  transacting individual stocks)