Buying Stock at Best Price Means Goldman Sachs Is No JPMorgan

By Edgar Ortega
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Aug. 18 (Bloomberg) -- There's an hour left before U.S. exchanges close, and order tickets are piling up for Michael Nasto, the senior trader at San Antonio-based money manager U.S. Global Investors Inc., which oversees $5.5 billion. It's June 26, and the Dow Jones Industrial Average has lost more than 300 points after a government report that the U.S. economy is slowing because of record oil prices.

Nasto fields questions from U.S. Global portfolio managers who are looking to take advantage of the sell-off. Brokers call to pitch trades in the energy and raw materials stocks they know are U.S. Global's specialty.

By the time the market closes, the Dow has dropped 358 points, for its second-worst percentage fall of the year, and Nasto has bought shares of a handful of oil and natural gas companies.

``We had some good pickups,'' he says. And the brokers he used got him good prices. ``You want to get that trade done with as little impact on the market as possible,'' Nasto says.

The global stock slump -- the MSCI World Index fell 20 percent from its Oct. 31, 2007 peak -- has heightened money managers' demand that their brokers execute trades at the lowest possible cost. Mutual funds and hedge funds gain an edge on rivals with every cent they shave off a stock purchase, or by unloading an investment without driving down a stock's price.

Big brokerages, bleeding from losses in mortgages and other loans, are earning more in commissions from stock trading than they have in eight years -- even while the Standard & Poor's 500 Index shows a total return of 1.7 percent in the eight years ended July 31 2008.

JPMorgan is No. 1

JPMorgan Chase & Co., the second-biggest U.S. bank by market value, is the most effective broker at getting good prices, according to data compiled for Bloomberg News by Ancerno Ltd., a New York-based firm that monitors trading costs in 57 countries.

When all of its trades were put together, New York-based JPMorgan diverged the least from the prices investors sought on stock sales and purchases for the 12-month period ended on March 31. JPMorgan also ranks No. 1 among brokers in Europe.

In the world ranking, JPMorgan customers lost an average of 0.105 percent, or 10.5 basis points, of performance when they bought or sold stocks through the bank, according to Ancerno. (A basis point is 0.01 percentage point.) A customer, for example, who placed an order to buy 50,000 shares that are selling for $10 each would receive the shares at an average cost of $10.01.

Trading on Surges

Zurich-based Credit Suisse Group AG ranks No. 2 worldwide, with aggregate stock trades diverging 13.1 basis points from order prices. It's followed closely by electronic broker Investment Technology Group Inc. of New York at 13.2 basis points.

Credit Suisse is also No. 1 worldwide in executing difficult trades -- buying a large number of shares as a stock surges or dumping an investment in the middle of a downdraft.

Zurich-based UBS AG was No. 4 in the global ranking, Bank of America Corp. No. 5 and Goldman Sachs Group Inc. No. 6. Ed Canaday, a spokesman for the New York-based investment bank, declined to comment on the rankings.

Weeden & Co., the 86-year-old privately held brokerage based in Greenwich, Connecticut, tops the ranking among North American brokers, while New York-based Sanford C. Bernstein & Co. ranks No. 2. Neither firm had enough trading volume outside North America to qualify for the Bloomberg/Ancerno global, European or Asian rankings. Australia's Macquarie Group Ltd. ranks No. 1 in Asia.

Costs a Priority

The days when a broker such as JPMorgan relied on relationships to lure new orders are long gone. Low costs are a top priority for investors, and brokerages tout their computer programming prowess along with their expertise in specific markets. They use complex algorithms to track the probability of completing a trade at a specific exchange or to predict a stock's price during the next 30 seconds.

An increasing share of trading is being done through brokerages' private electronic markets, known as dark pools--so called because they pair off orders without posting quotes on public exchanges.

Bloomberg LP, the parent of Bloomberg News, owns Bloomberg Tradebook LLC, an electronic brokerage that anonymously handles stock transactions in more than 35 countries.

The shift to electronic trading has eroded commissions to a little more than 3 cents per share in the U.S., turning equities into a low-margin business dependent on rising volumes. Still, it's a staple of every investment bank's repertoire, serving as a calling card for more-profitable areas such as lending money to hedge funds or securities underwriting.

Close Integration

``If you took the equity business away, you would destroy a series of other very profitable businesses,'' says Richard Bove, an analyst at Lutz, Florida-based Ladenburg Thalmann & Co. who has followed brokerages for 26 years. ``It's all very closely integrated to that effort.''

Institutional investors around the world paid $23.1 billion in trading commissions in 2007, up 21 percent from a year earlier, according to Greenwich Associates, a financial services consultant in Stamford, Connecticut. Those fees have become more important as the collapse of the U.S. mortgage market hobbles firms such as Merrill Lynch & Co. and Lehman Brothers Holdings Inc.

Even while credit markets froze and the merger advisory business dried up, stock exchanges from New York to London to Tokyo handled record trading volumes. The 10 busiest months ever for U.S. equity markets all came between August 2007 and August 2008, according to the New York Stock Exchange.

$7.5 Trillion in Trades

Ancerno, which was spun off in 2007 from Abel/Noser Corp., sells data gathered from about 500 clients, including the California Public Employees' Retirement System, or Calpers, and Valley Forge, Pennsylvania-based Vanguard Group Inc. The Bloomberg/Ancerno ranking measures the cost of $7.5 trillion worth of trades.

In the year ended on March 31, volumes surged to records as traders tried to take advantage of wide price swings in financial and other stocks triggered by the worldwide credit crunch. That's a milieu brokers love.

``The combination of volume and volatility is the broker's elixir,'' says Thomas Wright, global head of equity trading for Sanford C. Bernstein. ``But also, the stakes are higher because in that kind of environment you have to perform for clients.''

Bank of America has revamped its investment stock research to encompass insights from the fixed-income and options markets.

``As a broker, you have to work harder, and you have to work smarter,'' says Ciaran O'Kelly, head of global equities at the Charlotte, North Carolina-based bank.

`Rip Currents'

``The market is more complex, the cross-currents are more difficult to read, and the implications of getting caught in the rip current are drastic,'' he says.

JPMorgan cuts investors' overall transaction costs by pooling orders globally from institutions, wealthy individuals and traders looking to quickly hedge bets in derivatives markets, says Lee Cook, the firm's London-based head of cash equities trading for Europe, the Middle East and Africa. That allows the firm to complete more trades without posting quotes on public exchanges, which can spark a swing in a stock's price, Cook says.

JPMorgan's May purchase of Bear Stearns Cos. added electronic orders from hedge funds to the mix, particularly in the U.S., Cook says.

Firms such as U.S. Global, which manages nine equity mutual funds and two hedge funds, are trading more as they seek to capitalize on the volatility.

Getting Run Over

``With the price swings you have now, you can get run over,'' says Nasto, who has been an equities and derivatives trader for 13 years. ``But we don't mind the volatility because, basically, it presents more opportunities for us.''

For brokers, the big price swings can mean a shrinking customer base. Investors tend to send orders to fewer brokers during times of volatility, says Tim Mahoney, a 27-year veteran of Merrill's money management unit who now heads New York-based dark pool Bids Trading LP.

``I used to go to specific people on whom I had a high degree of confidence in their ability to execute in complex markets,'' says Mahoney. ``Relationships is too narrow a word. It was much more about my experience with individual brokers and specific stocks and circumstances, and clearly part of that was taking into account the transaction cost data.''

The shakeout in the brokerage industry has created opportunities for Weeden, says Barry Small, its chief executive officer. The firm increased its staff by 20 percent, hiring 45 people, in the last 18 months.

`Great Relationships'

``We've brought in people with great books of business, great relationships,'' says Small, who started at the firm in 1977. ``The combination of the older guard and the new guard, who bring best practices from other places, creates a very dynamic trading environment.''

Even before the recent market turmoil, smaller brokers were adjusting to regulations that allow investment firms to pay separately for investment research and brokerage services. ``Unbundling,'' as the process of breaking the tie between trading and research is called, was formally adopted by the U.K. and the U.S. in 2006.

Most money managers now channel orders to their most reliable brokers and pay directly for investment research instead of compensating analysts with trading commissions. Investment firms are also analyzing their transaction costs more easily and more often with software developed by firms such as Investment Technology Group and Ancerno.

Fewer Brokers

Hedge funds and institutional investors have pared their lists of U.S. brokers to an average of 47.1 this year from 52.7 in 2006, according to Greenwich Associates. Among the 272 funds surveyed by Greenwich, 44 percent said they planned further reductions to their broker lists.

In Europe, new regulations are forcing brokers to upgrade their systems to compete for trades. The European Commission's Markets in Financial Instruments Directive, or Mifid, enacted in November, gave brokers more flexibility to bypass exchanges and match trades on their own electronic markets to save investors money.

JPMorgan, its New York-based rival Citigroup Inc., Bank of America and Paris-based Credit Agricole SA's Cheuvreux unit are among brokers planning to introduce their own dark pools. Credit Suisse, Goldman Sachs and Lehman Brothers already operate internal trading systems.

Exchanges Respond

U.S. exchanges such as Nasdaq OMX Group Inc. and Kansas City, Missouri-based Bats Trading Inc. see Mifid as an opportunity to trade European stocks regardless of where they are listed. Incumbents such as the London Stock Exchange Group Plc and NYSE Euronext, which owns the Amsterdam and Paris bourses, hope to fend off the competition with new platforms of their own.

``It's very important to access all the main pools,'' says Philip Allison, head of equities trading in Europe at UBS and former chief of automated trading for the bank. That will require brokers to revamp computer systems to track quotes on many different markets and quickly route orders to the ones with the best prices. ``High-quality execution will require substantial resources,'' Allison says. ``Many firms will not be able to keep up.''

That means that the smaller, less-technology-oriented brokers may lose out. ``Our experience with the larger institutional clients is that brokerage lists are coming down -- and coming down quite dramatically,'' JPMorgan's Cook says.

New Hardware

Credit Suisse has spent more than $10 million on new computer hardware since volumes surged in July 2007. Speed and access to a greater number of markets give the brokerage an edge in handling difficult trades, says Dan Mathisson, head of the bank's Advanced Execution Services unit.

``When markets are whipping around a lot, being able to actually get the trade done becomes extremely important,'' he says. ``You need a huge investment in technology if you want to play the game.''

With the focus on lower-cost electronic trading, European investors may shed their reliance on human brokers, who as recently as 2005 handled more than 80 percent of shares traded. By 2010, their slice of the market will fall to 50 percent, according to a June survey of European funds by Tabb Group LLC, a Waltham, Massachusetts-based research firm.

Investment Technology Group is seeking to capitalize on the transformation, introducing new trading software that caters to money managers and hedge funds that are comfortable sidestepping brokers.

Goodbye, Human Brokers

``To say that investors are going to be dependent on large, bulge-bracket firms globally forever is unrealistic,'' says Robert Gasser, 43, the JPMorgan alumnus who heads Investment Technology. ``We fit into a different model.''

Tim Trebilcock, who oversees trading for Pittsburgh-based Federated Investors Inc., says it's a mistake for investment firms to whittle their broker lists too much.

``There are niche brokers that have expertise in specific markets or can excel with certain types of orders,'' says Trebilcock, whose firm managed $333.5 billion as of June 30. Still, with the unbundling of trade execution and research, a brokerage firm's ability to do trades at the best price has become paramount. Federated has started formally reviewing transaction data monthly -- rather than once a quarter -- to determine which brokers are doing trades at the best prices.

``It's a bit of a report card,'' says Trebilcock. ``If your broker isn't effectively helping you execute transactions, those costs can add up.''

And if the costs are too high, the brokers know the punishment is exile.

To contact the reporter on this story: Edgar Ortega in New York at ebarrales@bloomberg.net.