Searching for small wonders in big packages

As the macro-driven investment environment of the past three years gives way to a more differentiated approach, the attention of the buy-side is turning to the vexed question of how to ease the constraints on the trading of small-cap names.

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As the macro-driven investment environment of the past three years gives way to a more differentiated approach, the attention of the buy-side is turning to the vexed question of how to ease the constraints on the trading of small-cap names. Recent initiatives have included the release of new algos by Goldman Sachs and UBS specifically targeting illiquid small- and mid-cap shares as well as the arrival of AX, a trader-initiated call auction system that launched in November and saw its first trades in December last year.

“With small cap stocks, there is a relative unpredictability about how they will trade, so utilising algorithms that are based on historical schedules can be ineffective,” says Todd Lopez, co-head of Americas sales, Goldman Sachs Electronic Trading. There are also other aspects of an algorithm’s typical behaviour that need to be rethought. “We have to give the algorithm enough discretion to be opportunistic when liquidity materialises, but at the same time be patient enough to do nothing at all while it waits for liquidity to return,” says Lopez.

To achieve this, the algo essentially has to ensure representation in the public order book by using smart order types that leverage hidden orders, look for bonus liquidity across multiple dark pools, and at the same time be ready to seize any opportunity that may arise should outsize liquidity appear in the public market.

Key to successful small-cap trading is the search for blocks. “Traders in the small-cap space tend to focus on size priority to capture the alpha,” notes Brian Williamson, US equities analyst at Liquidnet. On any given day, 69% of US equities volume does not trade in a block format so block liquidity in general tends to be hard to come by. “That’s an important statistic to grasp and it’s the reason why Liquidnet appeals to small-cap traders,” says Williamson. “If you have a small-cap order on your blotter, you’re going to try and find the best source of liquidity right away and then follow up with other tools.”

Wielding the AX 

The arrival of the trader-initiated call auction system provided by the AX Trading Network has piqued the interest of traders on both buy- and sell-side. “The only new tool I’m looking at is AX,” says Kurt Kujawa, head equity trader of Milwaukee-based Cortina Asset Management, and a sceptic when it comes to algorithms. “There are a lot of things I like about it as well as some aspects I’m still not sure of, but it’s very intriguing.”

Mindful of the fear of information leakage in an open small-cap trading environment, the AX auction system is designed to help a trader search for liquidity in a protected way, says Kevin Callahan, CEO, AX Trading. “Our aim is to build a broad and diverse trading community because in small cap that’s what you need.”

Callahan describes the AX as an open community of buy- and sell-side, though most of the auctions at the moment are buy-side initiated. Essentially an initiator opens an auction by routing a firm committed order to the AX with a minimum of 25,000 shares. Initiators can control how much of the community they wish to expose the auction to. “This sits on our system for five minutes,” says Callahan. “Once we get that order, we send out an invitation to trade.” The message indicates that there is interest in a particular stock, but not whether the initiator is a buyer or seller. Recipients may send in an order of at least 10,000 shares. “It’s a sealed bid auction and the price has to be within 1% of the market,” says Callahan. “At the end of the five minutes, either the trades are matched up or the auction expires.” In February, of the 207 auctions on the AX, 28 attracted at least one participant order. Seventeen auctions – 8.2% – resulted in a successful match between buyers and sellers, with an average cross size of 32,500 shares.

Callahan acknowledges that the five-minute timeframe may seem like an eternity in today’s trading environment. “But our average order size is over 20% of average trading volume,” he notes. “For somebody to get 20% of ADV done in five minutes is pretty good.”

The struggle by traders to find small-cap liquidity on the one hand and by small firms to access the public markets on the other is also leading to renewed interest in mechanisms allowing exposure to private shares. Liquidnet is working on an offering of its own, while at least two other systems, Sharespost and SecondMarket, have attracted attention in the past few weeks. Whether or not this interest is restricted to pre-IPO stocks or is a sign of more significant developments, such as an alternative exit option for private equity investors, remains to be seen.

In mid-March, the Securities and Exchange Commission (SEC) charged SharesPost, an online service that matches buyers and sellers of pre-IPO stock, with engaging in securities transactions without registering as a broker-dealer. “While we applaud innovation in the capital markets, new platforms and products must obey the rules and ensure the basic fairness and disclosure that are the hallmarks of sound financial regulation,” said Robert Khuzami, director of the SEC’s Division of Enforcement. SecondMarket meanwhile has announced a10% staffing cut as pre-IPO trading in Facebook shares ceases ahead of an expected May listing.

Reporting by Richard Schwartz