Why is the NZX so small, what is its liquidity profile and why does liquidity vary on a day-to-day basis?

Two of the more important characteristics of any stock exchange are size and liquidity. Size is measured by the total capitalisation of all companies listed on an exchange and liquidity by the total value of shares traded on a daily, monthly or yearly basis.

The NZX is small in absolute terms, as one would expect for a country with only 4.58 million inhabitants, but it is still undersized even when compared with markets in other countries of a similar size.

However, the good news is that the NZX's liquidity is not out of line with these smaller markets.

Why is the NZX so small, what is its liquidity profile and why does liquidity vary on a day-to-day basis?

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The New York Stock Exchange (NYSE) is the world's largest exchange with a total capitalisation of US$19,351 billion at the end of 2014. This represented 30.5 per cent of the total capitalisation of US$63,530 billion of the 57 sharemarkets included in World Federation of Exchanges (WFE) statistics.

The Federation is a trade association for publicly regulated stock, futures and options exchanges.

The two US stock exchanges, the NYSE and NASDAQ, represent 41.4 per cent of total WFE's capitalisation.

The Tokyo Stock Exchange is the third largest exchange by total capitalisation, Shanghai SE is fourth and Euronext is fifth. Euronext, which was established in 2000, is an amalgamation of the Amsterdam, Brussels, London, Lisbon and Paris exchanges.

China has two exchanges in the top ten, Shanghai SE and Shenzhen SE. The latter has a relatively strong bias towards small and medium sized companies and new technology listings.

TMX Group, which is the seventh largest exchange, owns and operates the Toronto, Vancouver and Montreal stock exchanges.

India has two exchanges in the top group, BSE India in tenth position and National Stock Exchange India in eleventh. Both exchanges are based in Mumbai and the former, which was established in 1875, is Asia's oldest stock exchange.

There has been a major change in the pecking order of exchanges over the past decade as the four Chinese and Indian exchanges were not included in the top fifteen, by market capitalisation, at the end of 2004.

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The rural sector, the country's main economic engine, is under represented on the NZX and Fonterra, our largest company, is a co-operative and is not fully listed. In addition, New Zealand businesspeople have been reluctant to list their companies.

The NZX is a relatively small exchange with a total market capitalisation of just US$74 billion at the end of 2014. In terms of size it represents just 0.12 per cent of WFE's total capitalisation.

It is not surprising that the NZX is small, given the country's population of only 4.58 million. However, it is still relatively small when compared to the following countries with similar populations;

• Singapore, which has a population of 5.47 million, has a sharemarket value of US$753 billion

• Norway has a total share market value of US$219 billion and a population of 5.17 million

• Ireland, with a population of 4.61 million, has a sharemarket value of US$143 billion

The reasons for the small size of the NZX have been well and truly canvassed over the past few decades. One explanation is that the rural sector, the country's main economic engine, is under represented on the NZX and Fonterra, our largest company, is a co-operative and is not fully listed. In addition, New Zealand businesspeople have been reluctant to list their companies.

Argentina, another country with a strong rural base, also has a relatively small sharemarket. The Buenos Aires Stock Exchange has a capitalisation of just US$60 billion compared with the country's population of 42.61million.

In addition, New Zealand investors are also fairly risk averse and prefer to invest in residential property and bank term deposits rather than equities.

This is reflected in Reserve Bank household wealth data that shows New Zealanders had $719 billion invested in residential property, $129 billion in bank deposits and only $25 billion in direct domestic equities at the end of 2013.

The NZX also ranks towards the bottom of the table in terms of liquidity, which is measured by comparing the total value of trading during 2014 compared with year-end capitalisation.

The NZX has a 2014 liquidity ratio of 0.39 compared with 0.73 for the ASX and 1.69 for all WFE exchanges. A number of the world's larger exchanges, particularly the NASDAQ, Tokyo and the two Chinese markets, have liquidity ratios well above 1.0.

However, the NZX's 2014 liquidity ratio compares favourably with the Singapore, Oslo and Dublin exchanges which had 2014 ratios of 0.28, 0.67 and just 0.29 respectively.

The Buenos Aires market has a liquidity ratio of only 0.08.

It is inevitable that small markets are fairly illiquid but the NZX holds up reasonably well considering a number of its larger companies are over 50 per cent owned by the NZ Government or other controlling shareholders.

One of the unique features of the NZX, compared with most other markets, is that the majority of trades, in terms of value, are negotiated through brokers rather than going through the electronic market.

An electronic market is defined as one where buy and sell orders are placed through an exchange's electronic order book and can be seen by all market users. Negotiated deals are where buyers and sellers agree on price and quantity without putting their buy and sell orders through an electronic market.

WFE statistics show that 64 per cent of NZX trades by value in 2014 were negotiated through brokers, instead of going through the electronic order book system. This is very high compared with most other markets.

At the end of 2014 there were 44,516 companies listed on WFE exchanges. The NZX had 174 listed companies - 154 domestic and 20 foreign- while the ASX had 2,073 listings, 1,967 domestic and 106 foreign.

Thus the NZX has 0.39 per cent of WFE listed companies and 0.12 per cent of its capitalisation while the ASX had 4.66 per cent of the total listed companies and 2.03 per cent of total capitalisation.

One of the unique characteristics of the NZX is that it normally starts each day with a whimper but finishes with a bang.

These figures indicate that listed companies in Australasia are smaller, on average, than WFE companies as a whole.

NZX turnover can vary dramatically on a day-to-day basis. For example, average daily NZX turnover this month has been $164 million but on Friday March 20 the NZX reported turnover of $439 million.

This hike in turnover on March 20 was due to index changes where a number of companies were added or removed from an index or their weightings upgraded or downgraded.

On that day Orion Health was added to the NZX50 Gross Index and New Zealand Oil & Gas removed. Mighty River Power was upgraded from the FTSE small cap to mid-cap index while Heartland and Diligent were added to the FTSE small cap index and Synlait removed.

There were also a number of weighting changes to Australia's S&P's indices that impacted on Auckland Airport, Chorus, Fonterra, SkyCity, Fletcher Building, SkyTV, Spark and Trade Me.

Finally, one of the unique characteristics of the NZX is that it normally starts each day with a whimper but finishes with a bang.

An analysis of trading so far this year shows that only 12 per cent of daily trades are executed between 10am and 12am, 37 per cent between noon and 3pm and 51 per cent are completed after 3pm.

The reason for this is that Australian investors only become active on the NZX when their market opens at noon NZ time and Asian investors mainly participate from mid-afternoon onwards.

These figures clearly indicate that the NZX is relatively small and highly dependent on overseas participation to create liquidity.

Brian Gaynor is an executive director of Milford Asset Management.