- New Greenwich Associates Study Finds Low Volatility And Institutional Shift Out of Domestic Stocks Limiting Trading Volumes
- Lull in Trading Activity Slows Move to Electronic Execution
The long-awaited “Great Rotation” of assets out of fixed income following an uptick in rates will not necessarily reverse the long-term decline in institutional trading volume in U.S. equities, according to new research from Greenwich Associates.
At about 6.3 billion shares, Q1 2013 daily trading volume in U.S. equities is down by a third from the 2009 market high of roughly 9.3 billion. Equity brokers suffering from the pronounced slowdown in U.S. equity trading volumes had been hoping that an increase in interest rates might jumpstart trading activity. But recently, brokers have started planning for a new market normal in which trading volumes, commission payments and brokerage revenues hover close to today’s depressed levels. Brokers are now in a reset period in which they are scaling back their business structures to align with a U.S. equity market of about $9 billion-$10 billion in annual institutional commissions, as opposed to the $13.9 billion peak reached in 2009. As part of that process, brokers are taking aggressive steps to “right size” their businesses. Among the most prominent: Head-count reductions, desk consolidation and cuts in compensation.
When interest rates begin their climb back toward historic norms, it is virtually certain that some assets will flow out of fixed income and into equities. In a new report entitled, “U.S. Equities: Five Reasons Why the Great Rotation Might Not Be So Great,” Greenwich Associates makes the case that this asset shift is unlikely to lift to trading volumes and brokerage commissions back to prior highs.
Low Volatility and Changes in Investor Appetite Dampening Trade Activity
Eighty-one percent of the buy-side institutions participating in Greenwich Associates 2013 U.S. Equity Investors Study think U.S. equity market turnover will fail to rebound to pre-crisis levels by 2014. The past 12 months brought no recovery in trading activity, despite net inflows to U.S. equity portfolios among the institutions taking part in the study. More tellingly, the longer-term decline in trading activity has taken place amid historically strong equity markets. Institutional commission payments track with market volatility and, in recent years, have been inversely correlated with rising market valuations. This reflects investors’ confident buy-and-hold behavior on market ups and heavy trading on fear-induced sell-offs. “Given these patterns, it’s possible that even with a strong rally sparked by an influx of assets from investors fleeing fixed income, trading activity could be dampened by a continuation of the low volatility and volume that has characterized the recent run-up,” says Greenwich Associates analyst Kevin Kozlowski.
Institutional funds have been taking down U.S. equity allocations for years and are increasingly turning to passive U.S. equity strategies. Any major shift of assets into U.S. equities would seem to go against the long-term plans of most U.S. institutional funds, which as a group have embarked on a multi-year effort to reduce their exposure to domestic stocks. Among all U.S. pension funds, endowments and foundations, average allocations to domestic equities have declined from 45% of total assets in 2001 to just 27% in 2012. Nearly one-quarter of the institutional funds participating in the most recent Greenwich Associates U.S. Investment Management Study say they plan to further reduce domestic equity allocations in the next three years.
Greenwich Associates research, however, shows that U.S. defined benefit pension plans require returns of an average 7.4% to meet their long-term pension obligations. It is difficult to see how they could reach that goal with portfolios dominated by fixed income and interest rates poised to rise. The hot equity market could lure investors in but, alas, another cloud: Investor appetite is increasing for passive U.S. equity investments that produce far in the way of trading volume than active strategies.
Trading Lull Slows Move to Electronic Execution
When the share of institutional volume completed through traditional high-touch trades involving broker sales traders dropped to 56% in 2009 from 63% in 2007, it seemed that the U.S. equity market was on an inexorable path toward electronic execution. Instead, the share of U.S. equity trading volume executed through traditional high-touch trades has remained around 56% since 2009, save for a peak at 60% in 2011. One main reason: Institutional investors use commission payments to compensate brokers and other providers of U.S. equity research and advisory service. The drop in trade volumes and commission flows has reduced the amount of “currency” institutions have to pay for research and services deemed critical to their investment process by portfolio managers and analysts. One way institutions can solve this problem is by executing trades through higher cost, traditional trades facilitated by broker sales traders, as opposed to lower cost electronic trades.
“The slowdown in the growth of electronic trading can be attributed in part to the fact that institutions are routing trading volumes to high-touch execution in order to generate commissions to compensate brokers for research and other services,” says Greenwich Associates consultant John Colon. “Investors still have plans to significantly increase the share of their business done electronically over the next three years, but it remains to be seen if they will be able to achieve that goal.”