Wider Spreads and Fees Could Help Restore Investor Confidence

To rekindle interest in equities, a group of market experts called for wider spreads for less liquid stocks, and possibly even instituting a fee that would aid market making and research for these thin traders.

A diverse group of panelists at a Liquidnet-sponsored event in New York focused on how investors and companies have shunned the primary and secondary markets. The May 2010 flash crash and the more recent Facebook IPO debacle haven’t helped, so restoring confidence will be a tall order, panelists said.

“They feel the game is rigged to the point of where they are getting raped,” said Milton Ezrati, chief economist and market strategist at Lord Abbett, describing how retail investors feel toward equities. “There’s been a secular abandonment of equities, and there is no denying we are in extreme disfavor.”

To prove his point, Ezrati told attendees that since 2000, equities have underperformed bonds, posting a negative 10-year total return while U.S. Treasuries have managed an 8 percent return. 
“People don’t trust the system and feel the game is rigged,” he added. “People need to see that it is not.”

The remedies the panelists suggested are not foreign. Widening bid-offer spreads was a familiar call after the industry began trading in penny increments in 2001. Subsequently, as spreads narrowed, the average trade size dropped precipitously. But this idea never generated enough interest, as the industry adapted to the smaller trade size with electronic trading using algorithms.

However, emerging companies might be a different animal, and the recent JOBS Act has prompted another look at this topic. The Securities and Exchange Commission has been mandated to review spread size for small companies. The comment period to the SEC on this question ends July 5.

The call for a fee on trades for less liquid stocks would be akin to a 12b-1 fee that investors currently pay for mutual funds. Only in this case, the fee would go to support research and market making.

Jim Angel, associate professor at the McDonough School of Business at Georgetown University, is a proponent of both wider spreads and the fee. But he also had strong opinions elsewhere.

He said that small and emerging companies, not just mom-and-pop investors, are skittish about the equities markets and afraid to tap the markets.

“Fewer companies are willing to go public or stay public,” he said, citing a study that reported there are 50 percent fewer companies trading publicly today than 20 years ago. “And even formation of companies as private enterprises is dropping, because the exit strategy—starting to offer shares to public investors—is getting less and less attractive.”

Part of the problem, both Angel and Ezrati argue, is the narrowing of spreads, especially for small and emerging companies.  Georgetown’s Angel recommends moving away from sub-penny pricing, as high-frequency traders and the exchanges have advocated, and towards wider spreads. 

“If the spread needs to be a nickel, then it’s a nickel,” he said. “One-size tick does not fit all. There’s no reason there needs to be the penny spread that the Securities and Exchange Commission now mandates.”

Larry Tabb, chief executive of the Tabb Group, said dime spreads shouldn’t be off the table and considered as well.  This, he added, would incentivize brokers to trade and provide research for smaller and new companies.

Angel believes issuers, not the regulators, should decide what the spread should be in stocks. But if a company trades better with sub-penny pricing, “Then sub-penny should be permitted.”
Also, he called for a slight fee that investors would pay when trading small stocks. This fee would support market making and research, which would theoretically create interest in the stocks.

“I don’t know what the magic bullet is for our problems, but we need to do something,” Angel said. “We need to be open to experimentation and get confidence up and the markets moving.”