Mon, Jul 30, 2001 page24

• Big board begins invasion of land of Qs and spiders

  • By Dan Colarusso / NY TIMES NEWS SERVICE
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  Salvatore Sodano, the chairman of the American Stock Exchange, informed 700 securities firms earlier this month that the exchange was eliminating fees on some of its premier products, including the NASDAQ 100 Index Shares, known simply as the Q in the canyons of Lower Manhattan.

  Sodano's offer was not an act of charity but rather a counterattack.

  He was responding to the New York Stock Exchange, which tomorrow will begin trading three of the AMEX's most successful products -- exchange-traded funds based on the NASDAQ 100, the Standard & Poor's 500-stock index and the Dow Jones Industrial Average.

  Exchange-traded funds, securities built from baskets of stocks grouped by a particular sector or index, have become immensely popular trading vehicles for large and small investments alike, accounting for much of the recent success of the AMEX.

  The most widely traded of all the funds is the Q, which uses the ticker symbol QQQ and is sometimes called the Cube or Qube. Its shares mimic the performance of the NASDAQ 100, perhaps the most important technology stock index in the US.

  Diversification and lower fees

  Since the Q's debut in March 1999, investors have pumped more than US$24 billion into the fund. Its daily volume of more than 60 million shares is driven by the entire universe of traders, including hedge funds, mutual funds and individual investors seeking exposure to the technology sector. Investors have embraced exchange-traded funds, or ETFs, because they offer the diversification and low fees of traditional indexed mutual funds yet can be traded throughout the day.

  In addition, options based on the funds are used widely, and the funds can be sold short, a strategy that lets investors profit when share prices fall.

  Demand for exchange-traded funds has transformed the securities business.

  The Qs alone accounted for 70.7 percent of the 52 million shares the AMEX traded daily in 2000, on average. This year through June, they accounted for 53.2 percent of the average daily volume of 72 million shares. The exchange received US$0.60 to US$0.73 on most shares traded, fees that have fallen by the wayside as competition looms from the Big Board.

  A total of 106 funds trade on major exchanges, including spiders, as those that track the S&P 500 are known, and those tracking sectors like chemicals or real estate or national stock indexes from major markets like Japan to smaller ones like Belgium.

  Still, the New York Stock Exchange expects to start new funds of its own once it has seized a share of trading of the current funds. The AMEX is also planning new funds and has started AMEX ETF Services Ltd, a consultant for companies seeking to build funds, Sodano said.

  The exchange will seek patent protection on its next round of offerings, he said.

  Competition is rampant. Regional stock exchanges in Chicago, Boston and Cincinnati and electronic communications networks such as Archipelago and Island trade some of the larger exchange-traded funds.

  "The challenge is to take order flow and get the opportunity to build a new business, said Catherine Kinney, the head of client services at the Big Board.

  Looking for liquidity

  The AMEX, owned by the National Association of Securities Dealers, which also owns the NASDAQ, started the business in 1993, when it began listing the S&P 500 fund.

  "Nowhere in the world is there the level of expertise in these products," Sodano said. "We think that when there's a tough trade, our liquidity and experience will carry the day."

  Liquidity, the ability of an active market to buy or sell at a desired price, is the prime demand of the money managers who account for roughly 60 percent of volume in the Q.

  James McCall, the manager of the Merrill Lynch Focus 20 fund, said that when he sells a stock held by his fund, highly concentrated in technology, he puts the proceeds to work in the Q.

  "It's very liquid so you can buy and sell large blocks without moving the market," he said.

  It is easy for McCall and other money managers to hedge their positions because put and call options based on the Q trade on all five US options exchanges.

  The index is somewhat safer than an investment in shares of a single technology company.

  On Friday, Q shares rose by more than 2 percent, despite a 9.71 percent fall in the price of JDS Uniphase, which reported a huge write-off late Thursday.

  Not all professional traders love the Q.

  "It hardly gives you important diversification" even within the technology sector, said Charles Lemonides, the chief investment officer at M&R Capital Management of New York.

  Because the NASDAQ 100 index is capitalization-weighted, a handful of companies account for most of its value. "Sixteen stocks make up 50 percent of the index," he said. "If you want to buy 16 tech stocks, just go buy 16 tech stocks."

  Third market

  While the American and New York exchanges are competing for orders, major securities firms like Goldman Sachs, Morgan Stanley Dean Witter, the Salomon Smith Barney unit of Citigroup and Merrill Lynch are pushing to trade with their own customers without ever sending the order to an exchange.

  This trading, called the third market, accounts for half of Q business, more than the roughly 40 percent that is executed on the AMEX, traders said.

  The New York Stock Exchange will allow firms to "cross" exchange-traded fund orders -- Wall Street language for a firm's representing both the buyer and seller in a transaction -- that are larger than 25,000 shares, Kinney said.

  Earlier this year, the AMEX increased the amount of an order that brokers could match themselves to 40 percent from 20 percent. If the Big Board gets some of the business that brokers usually keep for themselves, it will be a strong contender for the entire market.

  "Liquidity breeds liquidity," said David Herron, the head of listed trading at Schwab Capital Markets, which sends orders to the AMEX, the Chicago Stock Exchange and Cincinnati and Boston markets based on execution quality and speed.

  The Chicago exchange stirred the competitive fires after it began listing Qs and spiders in July 1999 by paying brokers to send their orders to the exchange, a practice known as payment for order flow.

  That practice has been criticized as giving brokers an incentive other than finding the best prices for executing trades on a particular exchange.

  The AMEX rejected the idea of paying for orders earlier this year.

  Kinney said the New York Stock Exchange would not pay for order flow.

  For the exchanges, more than reputation is at stake, because exchange-traded fund offerings are expected to grow more popular with long-term investors, in addition to active traders.

  "Going forward, investors may use ETF products over the long term as opposed to using mutual funds," Herron said. "I don't think we've really seen that growth yet."
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