Vigilance Is Still the Watchword : Investing: The SEC’s proposed new rules would aid customers. Market officials say buy-and-hold policy is best for investors.
As the Justice Department and the Securities and Exchange Commission look into problems on Nasdaq, what can small investors do to protect themselves in the over-the-counter market?
For the moment, at least, Ron F. Keller of San Jose has chosen the most extreme solution: He says he has decided to stop buying Nasdaq stocks, even though some of the country’s fastest-growing companies are listed there.
Nasdaq has become the nation’s busiest stock market, with an average daily volume of nearly 300 million shares. As reported last week, the Justice Department’s antitrust division has said it is looking into alleged anti-competitive practices on Nasdaq, including possible price fixing by market makers.
Nasdaq and market makers have strongly denied there is any collusion.
Keller, a 59-year-old mechanical engineer who was forced to stop working because of medical problems, says he has spent much of his time over the last year trading Nasdaq and New York Stock Exchange stocks in his individual retirement account. But Keller says that in the last nine months, he has come to realize that spreads as wide as half a point on a $10 stock make the possibility of near-term profits remote. (Spreads are the gap between the price market makers are willing to pay to buy a stock and the price at which they are willing to sell.)
Efforts to get inside the spread by placing limit orders--orders to buy or sell only at a specified price-- haven’t worked for him.
Keller says he came to the decision to stop buying Nasdaq stocks on Oct. 14, after watching an interview on CNBC that led him to decide to buy shares immediately in Cyrix Corp., a Richardson, Tex.-based maker of microprocessors. He says he put in a limit order to buy 500 shares of the stock at $37.50, right in the middle of the spread of $37.25 bid, $37.75 asked. And as he continued to watch the TV screen, with the Nasdaq price tape flashing across the bottom, he saw trades being reported right at his price and better. Yet his limit order was never filled.
Keller, who uses deep-discount broker Waterhouse Securities, says his limit orders are almost never filled for Nasdaq stocks. “I feel I’m being treated unfairly,” he says.
John Chapel, the brokerage’s president, says the failure to execute the order was an inevitable consequence of the “extreme fragmentation” of the Nasdaq market. He says Waterhouse sent the order to an independent market maker for execution, but because that dealer wasn’t actively trading in Cyrix at the time, the limit order wasn’t filled.
But if the SEC goes ahead with plans to impose strict new protections for small investors’ limit orders, this problem is likely to be greatly improved. The SEC approved some new protections for customers’ limit orders in June. If it approves a proposed next step, as seems likely, the cardinal rule for small investors on Nasdaq will be to place limit orders, as opposed to ordinary “market orders” to buy at the prevailing market price. Market orders are almost always filled at the quoted bid or asked price, seldom in between.
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Under the new rules, market makers would no longer be allowed to let customers’ limit orders sit while they trade for themselves at better prices. So investors such as Keller would have a much better chance of getting their limit orders executed, thus circumventing the wide spreads. However, the proposed SEC rule would not require market makers to accept limit orders at all, raising fears that some might stop doing so.
Nor would the new rules fix the highly fragmented nature of the Nasdaq market, which has multiple market makers for each stock and many separate computer systems handling orders for the same stocks at the same time. This means, for example, that a customer placing a sell order through one brokerage house may still not get it filled even though a matching limit order to buy at that price is sitting unfilled at another brokerage house.
Experts say brokers seldom tell customers about the advantages of limit orders. Kevin D. Clark, vice president for trading at Milwaukee-based Heartland Value Fund, says that “retail (stock)brokers in general don’t want their clients to realize they can buy stock in between” the spreads by placing limit orders. One reason, he says, is that if the customer pays a lower price, the broker gets a lower commission.
Even with the improvements proposed by the SEC, customers will still need to be vigilant.
Veteran traders say investors should do as much independent research as possible about stocks before investing, and be especially wary of brokers who call them touting stocks, particularly if the broker says he can get it for you at a reduced or no commission.
Often, brokers get hidden payments known as “sales credits” from their firms’ trading desks for selling certain Nasdaq stocks--which customers seldom find out about. This occurs, for example, when a trading desk wants to get an unwanted position in a stock out of its inventory and calls on the brokers to sell it to the firms’ retail customers, in effect paying the broker a bonus for doing so. As a result, the broker may have a personal financial motive to push a stock that is not in customers’ best interests.
Michael Dayan, 71, owner of a dressmaking company in New York, contends in documents filed in an arbitration case that he learned this lesson the hard way. His broker, Jonathan Lyons, at brokerage firm Gruntal & Co., heavily recommended Candela Laser Corp., a Nasdaq stock. In April, 1992, Lyons allegedly told Dayan that Candela was a “definite” takeover target. (In fact, the company is still independent, and the stock, which Dayan bought at prices above $12 a share, is currently trading for less than $3.)
Based on the recommendation, Dayan in three transactions bought 53,500 shares of Candela. The confirmation slips Gruntal sent to Dayan after each trade showed that he had paid $17,134 in commissions. But documents obtained in the arbitration case show that, including the hidden sales credits to Lyons, the commissions totaled $27,490.
Harry D. Frisch, a lawyer for Gruntal, denied that Gruntal breaks any rules by not telling customers about the extra sales credits it pays to brokers, a position the National Assn. of Securities Dealers has generally agreed with. Lyons has denied any wrongdoing.
Jonathan Kord Lagemann, Dayan’s lawyer, says the only way customers can find out about the hidden credits is to ask--and hope the brokerage firm gives an answer. Often, he says, brokerage firms refuse to disclose the sales credits to customers.
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Veteran traders say that among other things customers can do to protect themselves:
* Invest in mutual funds instead of directly buying Nasdaq stocks. Mutual funds are usually able to buy Nasdaq stocks at prices inside the wide quoted spreads.
* Follow the advice of the NASD’s president, Joseph R. Hardiman: Buy and hold Nasdaq stocks for the long term; don’t do a lot of short-term trading. “Individuals should not trade a lot of stocks in the Nasdaq market,” he says. By holding growth stocks for the long term, the initial cost of spreads and commissions becomes much less significant.
But Harold Bradley, chief trader for the $27-billion Twentieth Century group of mutual funds in Kansas City, Mo., among others, says the steps individual investors can take are not enough. He says there must be additional action by securities regulators and even by Congress.
One step the securities industry has so far adamantly opposed is moving to “decimalization”--quoting stock prices in hundredths of a dollar instead of what many market experts view as an archaic system of eighths. For most stocks, the smallest allowed spread, or price move, is one-eighth, or 12.5 cents. Under decimalization, already widely used in foreign stock markets, the smallest move would be one penny. So prices of anywhere from, say, $20.01 to $20.99 would be possible.
Advocates of decimal pricing say the current system of eighths keeps spreads artificially wide. It also hinders competition on price, since one dealer competing with another may not be willing to drop its price an entire eighth, but might be willing to cut it by a penny or two.
Bradley and others say there should also be a move to one centralized computer system for handling Nasdaq limit orders. Such a centralized book already exists on the so-called auction markets, such as the NYSE. NASD Chief Operating Officer Richard G. Ketchum has said such a move would undermine Nasdaq as a “dealer” market in which multiple market makers compete on each stock, because it would hurt the market makers’ profitability.
But Bradley notes that most Nasdaq market makers themselves, as well as big institutional investors, now heavily use Instinet, a computerized system owned by Reuters, which in effect is a centralized limit-order book for the big players. It enables them to trade with each other instantaneously, getting prices inside the wide spreads. Small investors and even some small market makers don’t have access to it.
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How likely is it that there will be major changes on Nasdaq?
The Justice Department investigation is in its early stages, sources say, and price-fixing cases are often difficult to prove. Even if the department isn’t able to bring an antitrust case, however, Junius W. Peake, a finance professor at the University of Northern Colorado and a former vice chairman of the NASD’s board of governors, says he thinks the spotlight put on Nasdaq by the antitrust inquiry is likely to spur the SEC and the NASD itself to bring about changes, especially to narrow spreads and give more protection to small investors.
The SEC’s division of market regulation has direct responsibility for overseeing the NASD. It has come under some criticism in recent years for not cracking the whip more strongly. Critics note that there are longstanding relationships between SEC market regulation officials and the NASD.
Ketchum, the NASD chief operating officer, is a former SEC chief of market regulation. Brandon Becker, the current chief of market regulation, confirms that he is a personal friend of Ketchum’s and that the two in recent years have socialized at each other’s homes.
But both Becker and Ketchum strongly deny that this has had any influence on SEC regulation of the NASD.
SEC Chairman Arthur Levitt Jr. has indicated in public SEC meetings that he is anxious to move more quickly to remedy some inequities on Nasdaq.
In the meantime, investors and even executives of companies whose stocks are listed on Nasdaq say the market, divided up into 510 market-making firms for more than 4,800 stocks, is difficult to understand, sometimes preventing public investors from making intelligent decisions about buying and selling stocks.
About This Series
The electronic Nasdaq market has grown into the nation’s busiest marketplace for buying and selling stocks, with trading volumes exceeding those of the better-known New York Stock Exchange. Nasdaq is where investors trade shares of Intel, Microsoft, MCI, Apple Computer and other leading firms, as well as those of hundreds of smaller companies.
Critics are questioning the fundamental fairness of Nasdaq’s trading system, however, and the Justice Department has begun investigating alleged price fixing and other illegal activities.
Other stories that appeared in this series:
* THURSDAY: Close examination of Nasdaq shows the market is biased against small investors.
* FRIDAY: Investors often cannot get the best available price for Nasdaq trading because dealers ignore their orders.
* SATURDAY: What has happened to some of the reforms Nasdaq put in place after the October, 1987, stock market crash?
* SUNDAY: Dealers in Nasdaq stocks often refuse to make trades at posted prices, leaving small investors in the lurch.
* MONDAY: Some Nasdaq market makers wait hours before reporting big transactions, thus withholding information from investors.
* TODAY: How can the Nasdaq system be improved?
* SPREAD NARROWS: Market makers pared their profit margin on Intel stock. D6
* Series Reprints: A compilation of this six-part series on Nasdaq is available from Times on Demand. Price is $7.95, plus $2.50 for mail delivery. To order, call 808-8463 from the 213, 714, 818 or 909 area codes, then press *8630. Follow the voice instructions and select option 3. Order Item No. 8525. Allow two weeks for delivery.
