Comparing AAPLs and Apples
We recently talked about how, when you’re doing an analysis of stock markets and trading, it’s hard to compare AAPLs and oranges. We show that’s because market quality metrics – like spreads and depth – are driven more by other factors like market cap, sector volatility and company growth rates.
We also talked about how statisticians approach this – by “controlling for stock characteristics.” So that “everything else being equal and independently of the specification (cross-section or time series).”
Accounting for stock characteristics
So today, we’re going to see how stocks’ market quality compares – just by accounting for market capitalization. If you’re interested to see why market capitalization is an important driver of trading characteristics, read our prior research here. You can see even more detail by looking at liquidity, which is mostly driven by market capitalization too.
Both those studies show that looking at something as simple as the bid-offer spread, market capitalization and liquidity explain a large proportion of those costs to investors.
Slicing all stocks into market cap buckets, we can see that Nasdaq’s markets, set up to encourage more fair competition for quoting, do pretty well across each bucket.
Chart 1: Comparing spreads across market cap
Looking at depth (the amount of shares at the NBBO) is made a little more complicated by the fact that some stocks are tick constrained, giving investors trading them wider spread costs, which results in longer queues as investors try to save those spreads. Low-priced stocks also need to trade more shares just to add to the same value. With stock prices ranging from below $5 to well above $500, shares on the NBBO aren’t always a useful metric to show investors instantaneous liquidity.
In instances when stock prices are low, more depth isn’t necessarily a good thing – as it often comes with higher costs for investors.
Instead, investors typically care more about getting exposure to a company – as a proportion of their total portfolio. So, the value of shares available for a specific cost from the mid-point is a fairer comparison.
Looking at just large-cap stocks but assessing the spread costs to buy a set value of each stock, we can see that depth on the chosen primary market is cheaper for Nasdaq listings.
Chart 2: Comparing “depth” by looking at spread costs to buy equal notional exposure
Of course, close prices are probably the single most important price of the day. They are the prices that set mutual fund valuations and stock volatility and serve as the basis for most time series charts and return calculations.
Frequently, the close has very large liquidity demand or supply – often caused by index events or larger cashflows. Sometimes the excess liquidity moves the prices for stocks in the final minutes of the day.
That’s why we spend a lot of time researching our own auctions and modifying the rules to help reduce market-close volatility. Our rules are designed to help the market digest those spikes in liquidity with minimal contribution to prices in the final price for the day.
We update our new closing auction dislocation results below, again split by market capitalization. This shows that our close does, in fact, seem to contribute to lower volatility.
It’s not just our calculation methodology that shows this; academics have found the same, using much more sophisticated statistics. They found that “price deviations are 1.2 bps larger for NYSE auctions,” or about 18% worse on average. Another paper found that NYSE auction order imbalances and indicative prices are also less accurate, which can make NYSE auctions less efficient.
Chart 3: Comparing close volatility by venue across market cap
We also showed that sector classification matters a lot – as some sectors have more growth companies or news events than others – which affects cashflow certainty and, thus, valuations.
Looking at just the tech sector, across a number of metrics, we see again that companies listed on Nasdaq’s markets, which are set up to encourage more fair competition for quoting, have lower auction dislocations, intraday volatility and spreads across large-cap tech stocks.
Chart 4: Comparing market quality within the tech sector
Nasdaq listings have better market quality
When you account for characteristics of different stocks and sectors so you can better compare AAPLs with Apples, data shows Nasdaq listings have better market quality.
Lower spreads, more depth and less volatile closes. That’s good for investors, companies and markets overall.
Other Topics
Stocks US Markets
Phil Mackintosh
Nasdaq
Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency.
Read Phil's Bio