Selection of an equity investment strategy should depend, not only on the risk-adjusted returns the strategy is expected to generate, but also on a careful assessment of the liquidity of the issues used to execute the strategy and the size of the commitment required to implement the individual investment decisions. An examination of the “upstairs” dealer market indicates that these factors are critical in determining the cost of trading.

Not only does the basic market-maker’s spread increase sharply with decreasing market capitalization, but the total cost of trading (the spread plus price concessions and brokerage commissions) increases significantly as block size increases. The round-trip trading cost on a $5,000 block of small capitalization issues (under $10 million) will consume 17.3 per cent of the price; the spread/price cost for an equivalent block of large capitalization issues (over $1.5 billion) will be 1.1 per cent.

These results suggest that it would be unreasonable, given typical portfolio turnover rates, to expect actively managed small stock strategies on average to result in positive investment returns. They furthermore suggest that institutions with unusually large managed equity pools will find it difficult to execute individual stock transactions of significant value in any but the largest capitalization companies.