Decimal Wise, Pound Foolish?

The pricing of stocks in decimals, hailed three years ago as a big step forward for individual investors, is suddenly being questioned by powerful forces on Wall Street.

In decimal pricing, stocks are quoted in simple dollars and cents rather than in fractions. Aside from making prices easier to understand -- 69 cents, for example, instead of 11/16 -- the introduction of decimals in 2000 and 2001 was intended to reduce the hidden costs incurred by small investors.

But critics say so-called penny pricing has made trading more expensive for big institutional investors, such as insurance companies and pension and mutual funds. And because many institutional investors are essentially acting on behalf of individuals, some critics wonder whether decimalization is hurting more small investors than it’s helping.

William Donaldson, the new chairman of the Securities and Exchange Commission, has called for a review of decimal pricing. Richard Grasso, the chairman of the New York Stock Exchange, has said he’d like the SEC to do a test in which some stocks are priced in nickels.

Though changes in pricing increments may find some support, no one has suggested a return to fractions. And the current penny-pricing system has many strong backers, who say it has been a big benefit to individuals.

“Decimalization clearly has had positive impacts on the market,” said Craig Tyle, general counsel at the Investment Company Institute, the mutual fund trade group.

It’s unlikely that decimalization will be rolled back, in part because doing so would look like a sop to Wall Street, experts say. Penny pricing has sliced deeply into the profits of big investment banks. Given the cloud of scandal hanging over Wall Street, a move that aided brokerages at the perceived expense of small investors would create a stir.

Still, the discussion has reopened a larger debate about how to make the market a fairer place for small investors.

Decimalization has had two basic effects, most people agree.

It has narrowed the “spread” -- the difference between the price at which a brokerage will buy a stock from an investor and the price at which it will sell that same stock to another investor.

When spreads are narrowed, small investors can buy the average stock for a bit less and sell it for a bit more. In market parlance, penny pricing has improved the “inside” quote -- the highest bid to buy, and the lowest offer to sell, a stock.

But it also has had an unintended consequence: reducing the number of shares available at the inside quote.

Whereas 5,000 shares of a certain stock may have been available at the inside quote in pre-decimalization days, today there may be only 100. Thus the amount of stock available at the best price and the ability to easily execute a trade -- what market pros call “liquidity” -- have been reduced.

That means an institutional investor looking to buy 5,000 shares may have to make several smaller trades to acquire that much stock, potentially raising its overall trading costs.

To some experts, the liquidity problem stems not from penny pricing itself but from the strategies of some traders, particularly those on the NYSE. Specifically, decimal pricing has made it easier for traders to “penny jump” institutional orders.

Imagine that a large investor sends an order to buy 5,000 shares of XYZ stock. A trader, sensing that XYZ’s price is about to rise, jumps ahead of the investor by buying a block of XYZ shares at 1 cent more per share than the competing bid. The large investor might have to buy at a higher price from the penny-jumping trader -- a scenario that incenses institutions.

Fear of being penny-jumped has made some investors reluctant to place large orders, thus reducing liquidity.

The solution, some people say, would be for the NYSE to automatically execute many of the large orders that move through its trading system.

“We can have the benefits of decimalization and avoid the negative consequences, not by getting rid of decimalization but by undertaking other reforms,” said Tyle of the mutual fund trade group.

An NYSE spokesman declined to comment.

Many people believe that decimalization will be good for the markets in the long run and that institutional investors simply have to adapt their trading strategies.

“I don’t think decimalization has really hurt institutions,” said Ian Domowitz, managing director at ITG Inc., an institutional brokerage.

In the meantime, there is some debate about the overall effect of decimalization on small investors.

There’s broad agreement that lower spreads have helped small investors trading stocks on their own. But in the bear market, fewer people are doing that.

Instead, they’re relying more on mutual funds, and there is evidence that funds are encountering higher costs.

A study by a pair of finance professors at Vanderbilt University and Emory University found that actively managed funds are incurring higher trading costs after the switch to decimalization. Those costs could be lowering average annual returns by more than 1 percentage point -- a hefty price in an era of drooping performance. There is no effect on index funds, which do less trading.

“It’s clear evidence that, for mutual fund investors, decimalization has levied a cost on them,” said Nicolas Bollen, the Vanderbilt professor who co-wrote the study.