Imagine you’re an individual investor with shares in Diebold, the maker of ATMs and security systems. You’ve just sat down at the company’s annual shareholders meeting on June 2. Back stage, just minutes before taking the podium, CEO Thomas Swidarski learned the company’s share price has dropped 30 percent—in six seconds! You turn off your Blackberry so you’re no longer connected to the outside world.
Moments later, Diebold’s share price rockets back up and closes at $29.08, 3 percent above its opening. Trading volume, however, was 11 times its daily average. A review by the exchanges for misconduct or errors allows the day’s trading activity to stand. Bloomberg BusinessWeek later reports that the plunge may have occurred “when a shred of Diebold news bounced into the growing network of computer programs that search out financial information, analyze it, and trade instantly without human intervention” (emphasis added).
This is the world individual investors are facing today: a world of extreme volatility, lack of transparency in market activity, and lack of fairness when going up against the split-second capability of computerized trading without human intervention.
So how are the retail investors handling this? They pulled an estimated $14 billion from U.S. mutual funds in the week ending May 12—the first net withdrawal since March 2009, according to the Investment Company Institute. Meanwhile, the American Association of Individual Investors reported that its survey during the week of the May 6 ”flash crash” found bearish investor sentiment jumped to 36 percent, from 28 percent the week before.
The U.S. stock exchanges and the Securities and Exchange Commission still don’t know exactly how the May 6 flash crash happened. Trading experts say there was no root cause. It likely stemmed from a combination of overseas hedging, futures trading, and defects in market structure. But clearly investor confidence was shaken, and the SEC responded on June 10 by instituting more refined circuit breakers for individual stocks.
Joe Grills, a member of the NYSE Individual Investor Advisory Committee and the former chief investment officer of a large corporate pension fund says the new rules help, but “the retail investor is still at a significant disadvantage when compared to the high-speed frequent electronic trader who is trading on an information advantage. The issues are fairness and transparency. With the ability to trade in front of others, even if only in milliseconds, the high-speed trader gains an advantage that isn’t available to the retail investor. When transparency is added in, through such trading venues as dark pools, the retail investor is excluded from the price discovery of this trading and is clearly at an information disadvantage.”
Grillis’ answer to that problem: “The only solution to these problems is for the SEC to ban such high-frequency trading, flash trading, dark pools, and so forth from the U.S. markets.”
Clearly the individual investor is getting hammered in today’s trading environment—and executives involved in corporate governance need to be aware of that, because the retail investor is playing an increasing role in governance in the new proxy environment. With the SEC’s approval of amendments to the NYSE Rule 452, broker-dealers can no longer cast votes in director elections without direction from their retail clients. At the same time, companies would be wise to court their individual investors to cast votes in favor of management. Companies’ ability to communicate directly with their individual investors for proxy purposes would be much easier if the SEC were to rescind its Non-Objecting Beneficial Owner/Objecting Beneficial Owner (NOBO/OBO) rule from 1985.
And with new proxy disclosure rules adopted by the SEC in February, individuals and institutions will have a great deal more information about the board of directors: its diversity, leadership structure, qualifications, and role in risk management, to name a few. The SEC is also likely to adopt some form of shareholder access to the proxy statement in 2011; that means individual investors could be the swing vote for or against certain directors in contested elections. Advisory votes on executive pay will be another issue that will attract individual investors to vote their proxies.
Clearly the individual investor is getting hammered this year—and executives involved in corporate governance need to be aware of that, because the retail investor is playing an increasing role in governance.
Back to additional factors that are driving individuals out of the equities market to more stable but low-yielding investments: The unlevel playing field between the individual and institutional investor is largely caused by the use of algorithmic trading, also sometimes called automated trading or black-box trading. Mutual funds, pension funds, and other buy-side traders use the technique often: Institutional investors can break large trades into tranches to buy or sell through “dark pools” traded away from prying eyes of the exchanges, to avoid attention that might suggest a trade is based on inside information. Individual investors cannot see inside these black-box trades, nor can they participate in these schemes.
On June 22, the SEC hosted a panel to discuss market liquidity, but talk quickly turned from the fading concept of long-term investing to the world of high-frequency automated trading. In remarks prepared for the panel, Jeff Engelberg, a senior trader for Southeastern Asset Management said: “Contrary to the claim that speed reduces risk, the introduction of excessive speed and unrestrained technology destabilized the markets, and made them wholly indecipherable on May 6.”
This raises the question whether the SEC is still following its 75-year role of protecting the interests of the individual investor—or is it transitioning to regulating primarily the institutional side of the market? In 1950, retail investors owned more than 90 percent of the stock of U.S. corporations. By 1987, the pendulum began to swing toward the institutional investors as major shareholders in U.S. companies. Today, individual investors own less than 30 percent of U.S. corporate shares, and the New York Stock Exchange says that the trading volume in its listed companies represents less than 2 percent of total trading volume.
Alicia Davis Evans, in a May 2009 article in the Virginia Law Review titled “A Requiem for the Retail Investor,” says the SEC is well equipped to handle an institutionalized marketplace because this market is not actually “new.” Evans, a law professor at the University of Michigan, says the SEC has provided oversight to the evolving marketplace for decades. She cites Regulation Fair Disclosure as serving the needs of both the individual and institutional investors, and says the SEC’s push to institute “plain English” in disclosure documents benefits both retail and institutional investors.
Evans warns, “There is no reason to believe that a market without retail investors would be better than the status quo, and, indeed there is reason to fear that such a market would be worse.” She also notes that in 2006, approximately $5.5 trillion of U.S. equity investment dollars came from individual investors, up from $616 billion in 1965. Retail investors who put money into small-cap companies are particularly important, since many institutional investors are restricted by their ownership requirements to companies with a minimum size and share price. Because institutions own only a small percentage of the stock of small-cap corporations, Evans says, “retail investors are important for the survival of many of these firms.”
Some company executives may view the trend that individual investors are fleeing the equities market as good news; sometimes they can be pains in the neck when their demands are disproportionate to their relatively small share holdings. On the other hand, by taking a look at the big picture portrayed in this column, companies should hope that the SEC and the exchanges would address the issues of volatility, transparency, and fairness to make the equities market more appealing to individual investors.
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