Same Challenge, Different Year for Block Orders
Market volumes are down, volatility and risk-taking are muted, and high-frequency traders can slice and dice order sizes to frustratingly small sizes. Add it all up and it’s a very challenging landscape for institutional investors to efficiently buy and sell large blocks of equity.
But while today’s markets have their own unique phenomena to vex buy-side traders, they’re not necessarily any more perilous than the markets of three, five, or 10 or years ago.
“I’ve been at Vanguard 26 years, trading for 23, and I have never heard anyone say that liquidity is great and I often find the other side of my trade,” said Mike Buek, principal in Vanguard’s Equity Investment Group. “It has always been difficult, especially in small and mid-cap stocks, to find the other side.”
Average daily U.S. equity trading volume has steadily declined from almost 11 billion shares in the first quarter of 2009 to current levels of about six billion shares per day. That trend in isolation is undeniably bearish, but there a couple qualifying considerations: six billion shares per day is reasonably robust on a historical perspective, and early-2009 levels were related to the financial crisis and not sustainable.
While liquidity is a mixed bag, Buek noted that his group’s trading costs have declined by about one third or even one half since the early 2000s amid less information ‘leakage’ and tighter spreads.
More recently, data show that trading costs remain under control. For U.S. equities, total implementation shortfall costs, defined as the difference between the decision price of a trade and its execution price, have declined from about 65 basis points per share on average in mid-2009 to between 35 and 40 basis points per share more recently, according to Zeno Consulting Group.
“It doesn’t appear that liquidity is translating into higher trading costs,” said Steven Glass, chief executive of Zeno Consulting. At the same time, Glass noted it’s not clear that liquidity has helped push down trading costs either, as tools for sourcing liquidity have grown more robust and sophisticated.
Buek said middling liquidity can be a problem for market participants who need orders filled immediately, but it’s less of a concern for Vanguard and other institutions oriented toward longer-term investing.
“If I can’t find the other side quickly for a 50,000-share order, I’m willing to buy 100 shares at a time,” Buek told Markets Media. “It might take hours, but that’s okay if you don’t have urgency. For a trader trying to just do blocks and waiting around for that 50,000, you might not find that big chunk anymore. You have to be willing to do a little at a time…don’t force it.”
Vanguard sometimes uses derivatives to manage liquidity constraints in the equity market. “If we have cash flow coming in and we have stocks we want to buy that would cost too much to force in on that particular day, we’ll substitute, buy futures and then gradually buy the stocks and sell futures,” Buek said.
For an urgent trade in markets with questionable liquidity, Buek said a viable option is a principal bid, in which the investor shows the main characteristics of the trade to a few brokers who then bid on handling the business. “If you need to get into or out of your stock right away, it might cost 40 or 50 basis points but you can do it quickly,” Buek said. “Then the broker who has the flexibility can trade it over three or four days, with less impact.”
The ascendancy of high-frequency trading and the proliferation of trading venues to 13 U.S. stock exchanges and several dozen alternative trading systems have scattered liquidity over the past decade, noted Karim Taleb, principal of New York-based investment manager Robust Methods. More recently, there has been a aggravating “fear factor”, in which large investment organizations are wary of showing liquidity.
High-frequency trading “has made for a schism in markets”, Taleb said. “To a large extent it has helped the retail person, but the big institutions have moved to dark pools.”
“In the end, liquidity is financial risk and, with tighter spreads, there is less incentive to show liquidity,” Taleb continued. “So not only do you not see liquidity often, but when you do see it it’s in smaller amounts.”
Buek explained that an institutional trade can comprise multiple steps. “You always try to find the natural other side first,” he said. “You might go through a dark pool, or look if a broker has an (indication of interest). If there is a natural counterparty that you can find quickly, that’s great, but it doesn’t happen all the time.”
Fragmentation of trading venues comes with connectivity costs, but, according to Buek at Vanguard, the machines handle the bulk of the complexity. “We have algorithms and routing technology to make sure we pay attention to all the markets,” he said. “It’s not like I have to make sure I can’t forget about this market if the price is better, because our systems will go there automatically.”
Buek is not negative on current levels of liquidity, but he noted more broadly that the current century has lacked a true and sustained bull market, which in turn has limited participation. “It’s been tough over the last 12 years, as the market hasn’t done a whole lot, it’s been flat,” Buek said. “So some of the traditional big money managers are maybe not out there trading as much as they used to, or they are trading slower.”