It remains unclear how such link-ups will work, however. The notion is that members of one exchange should be able to trade products listed on another. So a Frenchman wanting to buy German government-bond futures could do so through a dealer on MATIF, even though the contract is actually traded in Frankfurt. That is easy to arrange via screen-based trading: all that are needed are local terminals. But linking an electronic market such as the DTB to a floorbased market with open-outcry trading such as MATIF is harder Nor have any exchanges thought through an efficient way of pooling their settlement systems
In any case, linkages and networks will do nothing to reduce the plethora of European exchanges, or to build a single market for the main European blue-chip stocks. For that a bigger joint effort is needed It would not mean the death of national exchanges, for there will always be business for individual investors, and in securities issued locally Mr Breuer observes that ultimately all business is local. Small investors will no doubt go on worrying about currency
risk unless and until monetary union happens. Yet large wholesale investors are already used to hedging against it. For them, investment in big European blue-chip securities would be much simpler on a single wholesale European market, probably subject to a single regulator
More to the point, if investors and issuers want such a market, it will emerge—whether today's exchanges provide it or not. What, after all, is an exchange? It is no more than a system to bring together as many buyers and sellers as possible, preferably under an agreed set of rules. That used to mean a physically supervised trading floor. But computers have made it possible to replicate the features of a physical exchange electronically. And they make the dissemination of prices and the job of applying rules to a market easier.
Most users of exchanges do not know or care which exchange they are using: they deal through brokers or dealers. Their concern is to deal with a reputable firm such as S. G. Warburg, Gold-man Sachs or Deutsche Bank, not a reputable exchange. Since big firms are now members of most exchanges, they can choose where to trade and where to resort to off-exchange deals—which is why there is so much dispute over market shares within Europe This fluidity creates much scope for new rivals to undercut established stock exchanges.
6.2 Europe, Meet Electronics
Consider the experience of the New York Stock Exchange, which has remained stalwartly loyal to its trading floor. It has been losing business steadily for two decades, even in its own listed stocks. The winners have included NASDAQ and cheaper regional exchanges. New York's trading has also migrated to electronic trading systems, such as Jeffries & Co's Posit, Reuters's Instinct and Wunsch (a computer grandly renamed the Arizona Stock Exchange).
Something similar may happen in Europe. OM, the Swedish options exchange, has an electronic trading system it calls Click. It recently renamed itself the London Securities and Derivatives Exchange. Its chief executive, Lynton Jones, dreams of offering clients side-by-side on a screen a choice of cash products, options and futures, some of them customised to suit particular clients The Chicago futures exchanges, worried like all established exchanges about losing market share, have recently launched "flex" contracts that combine the virtues of homogeneous exchange-traded products with tailor-made over-the-counter ones.
American electronic trading systems are trying to break into European markets with similarly imaginative products Instinet and Posit are already active, though they have had limited success so far. NASDAQ has an international arm in Europe. And there are homegrown systems, too. Tradepoint, a new electronic order-driver trading system for British equities, is about to open in London. Even bond-dealers could play a part. Their trade association, ISMA, is recognized British exchange for trading in Eurobonds; it has a computerized reporting system known as TRAX; most of its members use the international clearing-houses Euroclear and Cedel for trade settlement. It would not be hard for ISMA to widen its scope to include equities or futures and options. The association has recently announced a link with the Amsterdam Stock Exchange.
Electronics poses a threat to established exchanges that they will never meet by trying to go it alone. A single European securities market (or derivatives market) need not look like an established stock exchange at all. It could be a network of the diverse trading and settlement systems that already exists, with the necessary computer terminals scattered across the EC. It will need to be regulated at the European level to provide uniform reporting; an audit trail to allow deals to be retraced from seller to buyer; and a way of making sure that investors can reach the market makers offering the best prices. Existing national regulators would prefer to do all this through co-operation; but some financiers already talk of need for a European SEC. An analogy is European civil aviation’s reluctant inching towards a European system of air-traffic control.
Once a Europe-wide market with agreed regulation is in place, competition will window out the winners and losers among the member- bourses, on the basis of services and cost, or of the rival charms of the immediacy and size of quote-driven trading set against the keener prices of order-driven trading. Not a cosy prospect; but if the EC’s existing exchanges do not submit to such a European framework, other artists will step in to deny them the adventure.
7. NEW ISSUES
Up to now, we have talked about the function of securities markets as trading markets, where one investor who wants to move out of a particular investment can easily sell to another investor who wishes to buy. We have not talked about another function of the securities markets, which is to raise new capital for corporations–and for the federal government and state and local governments.
When you buy shares of stock on one of the exchanges, you are not buying a “new issue”. In the case of an old established company, the stock may have been issued decades ago, and the company has no direct interest in your trade today, except to register the change in ownership on its books. You have taken over the investment from another investor, and you know that when you are ready to sell, another investor will buy it from you at some price.
New issues are different. You have probably noticed the advertisements in the newspaper financial pages for new issues of stocks or bonds–large advertising which, because of the very tight restrictions on advertising new issues, state virtually nothing except the name of the security, the quantity being offered, and the names of the firms which are “underwriting” the security or bringing it to market.
Sometimes there is only a single underwriter; more often, especially if the offering is a large one, many firms participate in the underwriting group. The underwriters plan and manage the offering. They negotiate with the offering company to arrive at a price arrangement which will be high enough to satisfy the company but low enough to bring in buyers. In the case of untested companies, the underwriters may work for a prearranged fee. In the case of established companies, the underwriters usually take on a risk function by actually buying the securities from the company at a certain price and reoffering them to the public at a slightly higher price; the difference, which is usually between 1% and 7%, is the underwriters’ profit. Usually the underwriters have very carefully sounded out the demand is disappointing–or if the general market takes a turn for the worse while the offering is under way–the underwriters may be left with securities that can’t be sold at the scheduled offering price. In this case the underwriting “syndicate” is dissolved and the underwriters sell the securities for whatever they can get, occasionally at a substantial loss.
The new issue process is critical for the economy. It’s important that both old and new companies have the ability to raise additional capital to meet expanding business needs. For you, the individual investor, the area may be a dangerous one. If a privately owned company is “going public” for the fist time by offering securities in the public market, it is usually does so at a time when its earnings have been rising and everything looks particularly rosy. The offering also may come at a time when the general market is optimistic and prices are relatively high. Even experienced investors can have great difficulty in assessing the real value of a new offering under these conditions.
Also, it may be hard for your broker to give you impartial advice. If the brokerage firm is in the underwriting group, or in the “selling group” of dealers that supplements the underwriting group, it has a vested interest in seeing the securities sold. Also, the commissions are likely to be substantially higher than on an ordinary stock. On the other hand, if the stock is a “hot issue” in great demand, it may be sold only through small individual allocations to favored customers (who will benefit if the stock then trades in the open market at a price well above the fixed offering price)
If you are considering buying a new issue, one protective step you can take is to read the prospectus The prospectus is a legal document describing the company and offering the securities to the public. Unless the offering is a very small one, it can't be made without passing through a registration process with the SEC. The SEC can't vouch for the value of the offering, but it does act to make sure that essential facts about the company and the offering are disclosed in the prospectus.
This requirement of full disclosure was part of the securities laws of the 1930s and has been a great boon to investors and to the securities markets. It works because both the underwriters and the offering companies know that if any material information is omitted or misstated in the prospectus, the way is open to lawsuits from investors who have bought the securities.
In a typical new offering, the final prospectus isn't ready until the day the securities are offered. But before that date you can get a "preliminary prospectus" or "red herring"—so named because it carries red lettering warning that the prospectus hasn't yet been cleared by the SEC as meeting disclosure requirements
The red herring will not contain the offering price or the final underwriting arrangements But it will give you a description of the company's business, and financial statements showing just what the company's growth and profitability have been over the last several years It will also tell you something about the management. If the management group is taking the occasion to sell any large percentage of its stock to the public, be particularly wary.
It is a very different case when an established public company is selling additional stock to raise new capital. Here the company and the stock have track records that you can study, and it's not so difficult to make an estimate of what might be a reasonable price for the stock The offering price has to be close to the current market price, and the underwriters' profit margin will generally be smaller But you still need to be careful. While the SEC has strict rules against promoting any new offering, the securities industry often manages to create an aura of enthusiasm about a company when an offering is on the way On the other hand, the knowledge that a large offering is coming may depress the market price of a stock, and there are times when the offering price turns out to have been a bargain
New bond offerings are a different animal altogether. The bond markets are highly professional, and there is nothing glamorous about a new bond offering. Everyone knows that a new A-rated corporate
bond will be very similar to all the old A-rated bonds. In fact, to sell the new issue effectively, it is usually priced at a slightly higher "effective yield" than the current market for comparable older bonds—either at a slightly higher interest rate, or a slightly lower dollar price, or both. So for a bond buyer, new issues often offer a slight price advantage.
What is true of corporate bonds applies also to U.S. government and municipal issues. When the Treasury comes to market with a new issue of bonds or notes (a very frequent occurrence), the new issue is priced very close to the market for outstanding (existing) Treasury securities, but the new issue usually carries a slight price concession that makes it a good buy. The same is true of bonds and notes brought to market by state and local governments; if you are a buyer of municipals, these new offerings may provide you with modest price concessions. If the quality is what you want, there's no reason you shouldn't buy them—even if your broker makes a little extra money on the deal.
8. MUTUAL FUNDS. A DIFFERENT APPROACH
Up until now, we have described the ways in which securities are bought directly, and we have discussed how you can make such investments through a brokerage account.
But a brokerage account is not the only way to invest. For many investors, a brokerage has disadvantages–the difficulty of selecting an individual broker, the commission costs (especially on small transactions), and the need to be involved in decisions that many would prefer to leave to professionals. For people who feel this way, there is an excellent alternative available—mutual funds.
It isn't easy to manage a small investment account effectively. A mutual fund gets around this problem by pooling the money of many investors so that it can be managed efficiently and economically as a single large unit. The best-known type of mutual fund is probably the money market fund, where the pool is invested for complete safety in the shortest-term income-producing investments. Another large group of mutual funds invest in common stocks, and still others invest in long-term bonds, tax-exempt securities, and more specialized types of investments.
The mutual fund principle has been so successful that the funds now manage over $400 billion of investors' money—not including over $250 billion in the money market funds.
8.1 Advantages of Mutual Funds
Mutual funds have several advantages. The first is professional management. Decisions as to which securities to buy, when to buy and when to sell are made for you by professionals. The size of the pool makes it possible to pay for the highest quality management, and many of the individuals and organizations that manage mutual funds have acquired reputations for being among the finest managers in the profession.
Another of the advantages of a mutual fund is diversification. Because of the size of the fund, the managers can easily diversify its investments, which means that they can reduce risk by spreading the total dollars in the pool over many different securities. (In a common stock mutual fund, this means holding different stocks representing many varied companies and industries.)
The size of the pool gives you other advantages. Because the fund buys and sells securities in large amounts, commission costs on portfolio transactions are relatively low And in some cases the fund can invest in types of securities that are not practical for the small investor.
The funds also give you convenience First, it's easy to put money in and take it out The funds technically are "open-end" investment companies, so called because they stand ready to sell additional new shares to investors at any time or buy back ("redeem") shares sold previously You can invest in some mutual funds with as little as $250, and your investment participates fully in any growth in value of the fund and in any dividends paid out. You can arrange to have dividends reinvested automatically.
If the fund is part of a larger fund group, you can usually arrange to switch by telephone within the funds in the group—say from
a common stock fund to a money market fund or tax-exempt bond fund, and back again at will. You may have to pay a small charge for the switch. Most funds have toll-free "800" numbers that make it easy to get service and have your questions answered.
8.2 Load vs. No-load
There are "load" mutual funds and "no-load" funds. A load fund is bought through a broker or salesperson who helps you with your selection and charges a commission ("load")—typically (but not always) 8.5% of the total amount you invest. This means that only 91.5% of the money you invest is actually applied to buy shares in the pool. You choose a no-load fund yourself without the help of a broker or salesperson, but 100% of your investment dollars go into the pool for your account.
Which are better—load or no-load funds? That really depends on how much time and effort you want to devote to fund selection and supervision of your investment. Some people have neither the time, inclination nor aptitude to devote to the task—for them, a load fund may be the answer. The load may be well justified by long-term results if your broker or salesperson helps you invest in a fund that performs outstandingly well.