Stock market

trade futures and options. Here, the market which first trades a given

product tends to corner the business in it. The European Options Exchange

(EOE) in Amsterdam was the first derivatives exchange in Europe; today it

is the only one to trade a European equity-index option. London's LIFFE,

which opened in 1982 and is now Europe's biggest derivatives exchange, has

kept a two-to-one lead in German government-bond futures (its most active

contract) over Frankfurt's DTB, which opened only in 1990. LIFFE competes

with several other European exchanges, not always successfully: it lost the

market in ecu-bond futures to Paris's MATIF.

European exchanges armoured themselves for this battle in three ways.

The first was to fend off foreign competition with rules. In three years of

wrangling over the EC's investment-services directive, several member-

countries pushed for rules that would require securities to be traded only

on a recognized exchange. They also demanded rules for the disclosure of

trades and prices that would have hamstrung SEAQ's quote-driven trading

system. They were beaten off in the eventual compromise, partly because

governments realized they risked driving business outside the EC. But

residual attempts to stifle competition remain. Italy passed a law in 1991

requiring trades in Italian shares to be conducted through a firm based in

Italy. Under pressure from the European Commission, it may have to repeal

it.

6.1 New Ways for Old

The second response to competition has been frantic efforts by bourses

to modernize systems, improve services and cut costs. This has meant

investing in new trading systems, improving the way deals are settled, and

pressing governments to scrap stamp duties. It has also increasingly meant

trying to beat London at its own game, for instance by searching for ways

of matching London's prowess in block trading.

Paris, which galvanized itself in 1988, is a good example. Its bourse

is now open to outsiders. It has a computerized trading system based on

continuous auctions, and settlement of most of its deals is computerized.

Efforts to set up a block-trading mechanism continue, although slowly.

Meanwhile, MATIF, the French futures exchange, has become the continent's

biggest. It is especially proud of its ecu-bond contract, which should grow

in importance if and when monetary union looms.

Frankfurt, the continent's biggest stock-market, has moved more

ponderously, partly because Germany's federal system has kept regional

stock exchange in being, and left much of the regulation of its markets at

Land (state) level. Since January 1st 1993 all German exchanges (including

the DTB) have been grouped under a firm called Deutsche Borse AG, chaired

by Rolf Breuer, a member of Deutsche Bank’s board. But there is still some

way to go in centralizing German share-trading. German floor brokers

continue to resist the inroads made by the bank’s screen-based IBIS trading

system. A law to set up a federal securities regulator (and make insider-

dealing illegal) still lies becalmed in Bonn.

Other bourses are moving too. Milan is pushing forward with screen-

based trading and speeding up its settlement. Spain and Belgium are

reforming their stock-markets and launching new futures exchanges.

Amsterdam plans an especially determined attack on SEAQ. It is implementing

a McKinsey report that recommended a screen-based system for wholesale

deals, a special mechanism for big block trades and a bigger market-making

role for brokers.

Ironically, London now finds itself a laggard in some respects. Its

share settlement remains prehistoric; the computerized project to modernize

it has just been scrapped. The SEAQ trading system is falling apart; only

recently has the exchange, belatedly, approves plans draw up by Arthur

Andersen for a replacement, and there is plenty of skepticism in the City

about its ability to deliver. Yet the exchange’s claimed figures for its

share of trading in continental equities suggest that London is holding up

well against its competition.

Are these figures correct? Not necessarily: deals done through an agent

based in London often get counted as SEAQ business even when the

counterpart is based elsewhere and the order has been executed through a

continental bourse. In today’s electronic age, with many firms members of

most European exchanges, the true location of a deal can be impossible to

pin down. Continental bourses claim, anyway, to be winning back business

lost to London.

Financiers in London agree that the glory-days of SEAQ’s international

arm, when other European exchanges were moribund, are gone. Dealing in

London is now more often a complement to, rather than a substitute for,

dealing at home. Big blocks of stock may be bought or sold through London,

but broken apart or assembled through local bourses. Prices tend to be

derived from the domestic exchanges; it is notable that trading on SEAQ

drops when they are closed. Baron van Ittersum, chairman of the Amsterdam

exchange, calls this the “queen’s birthday effect”: trading in Dutch

equities in London slows to a trickle on Dutch public holidays.

Such competition-through-diversity has encourage European exchanges to

cut out the red tape that protected their members from outside competition,

to embrace electronics, and to adapt themselves to the wishes of investors

and issuers. Yet the diversity may also have had a cost in lower liquidity.

Investors, especially from outside Europe, are deterred if liquidity

remains divided among different exchanges. Companies suffer too: they

grumble about the costs of listing on several different markets.

So the third response of Europe’s bourses to their battle has been pan-

European co-operative ventures that could anticipate a bigger European

market. There are more wishful words here than deeds. Work on two joint EC

projects to pool market information, Pipe and Euroquote, was abandoned,

thanks mainly to hostility from Frankfurt and London. Eurolist, under which

a company meeting the listing requirements for one stock exchange will be

entitled to a listing on all, is going forward–but this is hardly a single

market. As Paris’s Mr Theodore puts it, "there is a compelling business

case for the big European exchanges building the European-regulated market

of to-morrow" Sir Andrew Hugh-Smith, chairman of the London exchange has

also long advocated one European market for professional investors

One reason little has been done is that bourses have been coping with

so many reforms at home. Many wanted to push these through before thinking

about Europe. But there is also atavistic nationalism. London, for example,

is unwilling to give up the leading role it has acquired in cross-border

trading between institutions; and other exchanges are unwilling to accept

that it keeps it. Mr. Theodore says there is no future for the European

bourses if they are forced to row in a boat with one helmsman. Amsterdam's

Baron van Ittersum also emphasises that a joint European market must not be

one under London's control.

Hence the latest, lesser notion gripping Europe's exchanges: bilateral

or multilateral links. The futures exchanges have shown the way. Last year

four smaller exchanges led by Amsterdam's EOE and OM, an options exchange

based in Sweden and London, joined together in a federation called FEX In

January of this year the continent's two biggest exchanges, MATIF and the

DTB, announced a link-up that was clearly aimed at toppling London's LIFFE

from its dominant position Gerard Pfauwadel, MATIF's chairman, trumpets the

deal as a precedent for other European exchanges. Mr Breuer, the Deutsche

Borse's chairman, reckons that a network of European exchanges is the way

forward, though he concedes that London will not warm to the idea. The

bourses of France and Germany can be expected to follow the MATIF/DTB lead.

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.

In recent years, some successful funds that were previously no-load

have introduced small sales charges of 2% or 3%. Often, these "low-load"

funds are still grouped together with the no-loads, you generally still buy

directly from the fund rather than through a broker. If you are going to

buy a high-quality fund and hold it a number of years, a 2% or 3% sales

charge shouldn't discourage you.

8.3 Common Stock Funds

Apart from the money market funds, common stock funds make up the

largest and most important fund group. Some common stock funds take more

risk and some take less, and there is a wide range of funds available to

meet the needs of different investors.

When you see funds "classified by objective", the classifications are

really according to the risk of the investments selected, though the word

"risk" doesn't appear in the headings. "Aggressive growth" or "maximum

capital gain" funds are those that take the greatest risks in pursuit of

maximum growth. "Growth" or "long-term growth" funds may be a shade lower

on the risk scale. "Growth-income" funds are generally considered middle-of-

the-road. There are also common stock "income" funds, which try for some

growth as well as income, but stay on the conservative side by investing

mainly in established companies that pay sizable dividends to their owners.

These are also termed "equity income" funds, and the best of them have

achieved excellent growth records.

Some common stock funds concentrate their investments in particular

industries or sectors of the economy. There are funds that invest in energy

or natural resource stocks; several that invest in gold-mining stocks,

others that specialize in technology, health care, and other fields.

Formation of this type of specialized or "sector" fund has been on the

increase.

8.4 Other Types of Mutual Funds

There are several types of mutual funds other than the money market

funds and common stock funds. There are a large number of bond funds,

investing in various assortments of corporate and government bonds There

are tax-exempt bond funds, both long-term and shorter-term, for the high-

bracket investor There are "balanced" funds which maintain portfolios

including both stocks and bonds, with the objective of reducing risk And

there are specialized funds which invest in options, foreign securities,

etc.

8.5 The Daily Mutual Fund Prices

One advantage of a mutual fund is the ease with which you can follow a

fund's performance and the daily value of your investment. Every day,

mutual fund prices are listed in a special table in the financial section

of many newspapers, including the Wall Street Journal. Stock funds and bond

funds are listed together in a single alphabetical table, except that funds

which are part of a major fund group are usually listed under the group

heading (Dreyfus, Fidelity, Oppenheimer, Vanguard, etc.).

The listings somewhat resemble those for inactive over-the-counter

stocks. But instead of "bid" and "asked", the columns are usually headed

"NAV" and "Offer Price". "NAV" is the net asset value per share of the

fund. it is each share's proportionate interest in the total market value

of the fund's portfolio of securities, as calculated each night It is also,

generally, the price per share at which the fund redeemed (bought back)

shares submitted on that day by shareholders who wished to sell The "Offer

Price" (offering price) column shows the price paid by investors who bought

shares from the fund on that day. In the case of a load fund, this price is

the net asset value plus the commission 01 "load" In the case of a no-load

fund, the symbol "N.L." appears in the offering price column, which means

that shares of the fund were sold to investors at net asset value per

share, without commission. Finally, there is a column on the far right

which shows the change in net asset value compared with the previous day.

8.6 Choosing a Mutual Fund

Very few investments of any type have surpassed the long-term growth

records of the best-performing common stock funds. It may help to say more

about how you can use these funds.

If you intend to buy load funds through a broker or fund salesperson,

you may choose to rely completely on this person's recommendations. Even in

this case, it may be useful to know something about sources of information

on the funds.

If you have decided in favor of no-load funds and intend to make your

own selections, some careful study is obviously a necessity. The more you

intend to concentrate on growth and accept the risks that go with it, the

more important it is that you entrust your money only to high-quality,

tested managements.

There are several publications that compile figures on mutual fund

performance for periods as long as 10 or even 20 years, with emphasis on

common stock funds. One that is found in many libraries is the Wiesenberger

Investment Companies Annual Handbook. The Wiesen-berger Yearbook is the

bible of the fund industry, with extensive descriptions of funds, all sorts

of other data, and plentiful performance statistics. You may also have

access to the Lipper Mutual Fund Performance Analysis, an exhaustive

service subscribed to mainly by professionals. It is issued weekly, with

special quarterly issues showing longer-term performance. On the

newsstands, Money magazine publishes regular surveys of mutual fund

performance; Barren's weekly has quarterly mutual fund issues in mid-

February, May, August and November; and Forbes magazine runs an excellent

annual mutual fund survey issue in August.

These sources (especially Wiesenberger) will also give you description

of the funds, their investment policies and objectives. When you have

selected several funds that look promising, call each fund (most have toll-

free "800" numbers) to get its prospectus and recent financial reports. The

prospectus for a mutual fund plays the same role as that described in "New

Issues." It is the legal document describing the fund's history and

policies and offering the fund's shares for sale. It may be dry reading,

but the prospectus and financial reports together should give you a picture

of what the fund is trying to do and how well it has succeeded over the

latest 10 years.

In studying the records of the funds, and in requesting material, don't

necessarily restrict yourself to a single "risk" group. The best investment

managers sometimes operate in ways that aren't easily classified. What

counts is the individual fund's record.

Obviously, you will want to narrow your choice to one or more funds

that have performed well in relation to other funds in the same risk group,

or to other funds in general. But don't rush to invest in the fund that

happens to have performed best in the previous year; concentrate on the

record over five or ten years. A fund that leads the pack for a single year

may have taken substantial risks to do so. But a fund that has made its

shareholders' money grow favorably over a ten-year period, covering both up

and down periods in the stock market, can be considered well tested. It’s

also worth looking at the year-to-year record to see how consistent

management has been.

You will note that the range of fund performance over most periods is

quite wide. Don’t be surprised. As we have stressed, managing investments

is a difficult art. Fund managers are generally experienced professionals,

but their records have nevertheless ranged from remarkably good to mediocre

and, in a few cases, quite poor. Pick carefully.

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