Electronic Trading: Electronic Communications Networks (ECNs)

An electronic communication network (ECN) is an electronic system that attempts to facilitate (for market makers) or eliminate (for individual investors) third party orders entered by a client's brokerage to be executed in whole or in part. ECNs network major brokerages and traders so that they can trade between themselves without having to go through a middleman. The advantage of an ECN is that it displays orders in real time, whereas on the NYSE, most investors are limited to only viewing the best bid and ask prices. (For related reading, see Direct Access Trading Systems and Introduction To Level II Quotes.)

There are several variations of ECNs in the market, each of which are slightly different. Here are some of the more popular ones and a summary of their basic characteristics:

Instinet
Instinet was the first ever ECN, founded in 1969. It was originally a way for brokerages to display bid and ask prices for practically every stock in North America and abroad and was first used by institutions to transact with each other. Today it also includes a select group of smaller brokerages. Instinet is used to execute a large proportion of orders on Nasdaq and is primarily entered by market makers. Because of this exclusive access many of the large block orders on Nasdaq stocks are traded through Instinet. More recently, Instinet has tried to level the playing field by lowering access fees and allowing individual investors and small firms to access its orders.

SelectNet
This electronic system is primarily used for trading between market makers. SelectNet is known as a negotiable system, which means that market makers may or may not execute your order immediately, as on other ECNs, although they are required to execute immediately if the order is at the advertised price and it appears on the market maker's screen. SelectNet is popular among traders because orders can be preferenced, which allows a trader to isolate and trade with a particular market maker. This is advantageous because traders can target market makers who are active in the stock he/she wants to trade. This way the trader will get immediate attention, which usually results in a faster execution.

There are a few networks that are used to facilitate trading on Nasdaq stocks. One, the small order execution system (SOES), we will discuss next, but there are also other ECNs offered by Bloomberg, Terra Nova and others.

Electronic Trading: The Nasdaq Vs. The NYSE

From a glance, the difference between the New York Stock Exchange (NYSE) and Nasdaq may not be marked. The NYSE lists household names like Coca-Cola, Wal-Mart, Citicorp, and General Electric, whereas the Nasdaq is home to many of the tech giants such as Microsoft, Cisco, Intel, Oracle and Sun Microsystems. Besides the heavy tech weighting, the fundamental difference between the two exchanges is in the way securities are traded.

NYSE

The NYSE is an auction market that uses floor traders to make most of its trades. Each stock on the NYSE has a specialist; this is a person who oversees and facilitates all of the trades for a particular stock. If you wish to buy a stock that trades on the NYSE, your broker will either call your order to a floor broker, or enter it into the DOT system (which we will discuss later on). (For more insight, see Markets Demystified and The Tale Of Two Exchanges: NYSE and Nasdaq.)

Nasdaq

The Nasdaq, on the other hand, is not a physical entity. The Nasdaq might be known for its fancy MarketSite Tower and broadcast studio in Times Square, but very little is done there. The Nasdaq is an over-the-counter (OTC) market and it relies on market makers rather than specialists to facilitate trading and liquidity in stocks. For each stock, there is at least one market maker, (large stocks such as Microsoft have several), whose duties we will discuss later on. (Want to learn more? Read What's the difference between a Nasdaq market maker and a NYSE specialist?)

Rather than being an auction market, the Nasdaq is a communications network between thousands of computers. Instead of brokers calling out orders, market makers place their names on a list of buyers and sellers, which is then distributed by the Nasdaq in a split second to thousands of other computers. If you wish to buy a stock that trades on the Nasdaq, your broker will either call up a market maker with the information of your trade or enter your order into a Nasdaq-sponsored online execution system.

Stock-Picking Strategies: Dogs of the Dow

The investing strategy which focuses on Dogs of the Dow was popularized by Michael Higgins in his book, "Beating the Dow". The strategy's simplicity is one of its most attractive attributes. The Dogs of the Dow are the 10 of the 30 companies in the Dow Jones Industrial Average (DJIA) with the highest dividend yield. In the Dogs of the Dow strategy, the investor shuffles around his or her portfolio, adjusting it so that it is always equally allocated in each of these 10 stocks.

Typically, such an investor would need to completely rid his or her portfolio of about three to four stocks every year and replace them with different ones. The stocks are usually replaced because their dividend yields have fallen out of the top 10, or occasionally, because they have been removed from the DJIA altogether.

Is it Really that Simple?
Yes, this strategy really is as simple as it sounds. At the end of every year, you reassess the 30 components of the DJIA, determine which ones have the highest dividend yield, and ask your broker to make your portfolio as equally weighted in each of these 10 stocks as possible. Hold onto these 10 stocks for one calendar year, until the following Jan 1, and repeat the process. This is a long-term strategy, requiring a long period to see results. There have been a few years in which the Dow has outperformed the Dogs, so it is the long-term averages that proponents of the strategy rely on.

The Premise
The premise of this investment style is that the Dow laggards, which are temporarily out-of-favor stocks, are still good companies because they are still included in the DJIA; therefore, holding on to them is a smart idea, in theory. Once these companies rebound and the market has revalued them properly (or so you hope), you can sell them and replenish your portfolio with other good companies that are temporarily out of favor. Companies in the Dow have historically been very stable companies that can weather any market decline with their solid balance sheets and strong fundamentals. Furthermore, because there is a committee perpetually tinkering with the DJIA's components, you can rest assured that the DJIA is made up of good, solid companies.

By the Numbers
As mentioned earlier, one of the big attractions of the Dogs of the Dow strategy is its simplicity; the other is its performance. From 1957 to 2003, the Dogs outperformed the Dow by about 3%, averaging a return rate of 14.3% annually whereas the Dows averaged 11%. The performance between 1973 and 1996 was even more impressive, as the Dogs returned 20.3% annually, whereas the Dows averaged 15.8%.

Variations of the Dogs
Because of this strategy's simplicity and its returns, many have tried to alter it in an attempt to refine it, making it both simpler and higher yielding. There is the Dow 5, which includes the five Dogs of the Dow that have the lowest per share price. Then there is the Dow 4, which includes the 4 highest priced stocks of the Dow 5. Finally, there is the Foolish 4, made famous by the Motley Fool, which chooses the same stocks as the Dow 4, but allocates 40% of the portfolio to the lowest priced of these four stocks and 20% to the other three stocks.

These variations of the Dogs of the Dow were all developed using backtesting, or testing strategies on old data. The likelihood of these strategies outperforming the Dogs of the Dow or the DJIA in the future is very uncertain; however, the results of the backtesting are interesting. The table below is based on data from 1973-1996.



Before you go out and start applying one of these strategies, consider this: picking the highest yielding stocks makes some intuitive sense, but picking stocks based strictly on price seems odd. Share price is a fairly relative thing; a company could split its shares but still be worth the same, simply having twice as many shares with half the share price. When it comes to the variations on the Dogs of the Dow, there are many more questions than there are answers.




Dogs Not Fool Proof
As is the case with the other strategies we've looked at, the Dogs of the Dow strategy is not fool-proof. The theory puts a lot of faith in the assumption that the time period from the mid-20th century to the turn of the 21st century will repeat itself over the long run. If this assumption is accurate, the Dogs will provide about a 3% greater return than the Dow, but this is by no means guaranteed.

Conclusion
The Dogs of the Dow is a simple and effective strategy based on the results of the last 50 years. Pick the 10 highest yielding stocks of the 30 Dow stocks, and weigh your portfolio equally among them, adjusting the portfolio annually, and you can expect about a 3% outperformance of the Dow. That is, if history repeats itself.