Sweating the small stuff

In a world where thinking big is no longer the solution, brokers are beginning to understand that the buy-side is seeking alpha in the small stuff.

By None

I’m a big game hunter…Why should I care about small-cap algos? 

If you work for a long-only investment house looking chiefly at large-caps, then you know how depressed returns have been recently. More often than not, small-caps can offer higher rates of growth.

In such a climate, small-caps are being subjected to increasing scrutiny by investors eyeing opportunities, so you need to understand how to access them without moving the market.

Recently, a new electronic trading community was set up in the US for small-cap stocks and other thinly-traded securities.

Last month, members of the AX Trading Network conducted over 200 unique auctions, with an average initiated order size of 83,000 shares, meaning that there were 17.3 million shares put up for auction. While these aren’t huge volumes in the context of the overall market, it shows a growing demand for new ways to access small-cap liquidity.

The AX Trading Network now claims to have signed up over 650 buy-side institutions, representing almost 60% of the long-only investment community and a quarter of the hedge fund community in the US.

And earlier this month, Russell Investments launched a small-and mid-cap European index, designed to be used as the basis of investable products, with its key feature being its tradability. The Russell Europe SMID 300 Index bills itself as the first index of highly liquid, rapidly tradable small- and mid-cap European stocks.

Clearly it’s an asset class I need to track more carefully…But can algos really capture small-cap liquidity? 

The main difference between small-cap algos and those designed for large caps seems to be that they are less rigorous in their scheduling and more opportunistic when they find liquidity. This lets the algo grab liquidity when it comes along, rather than forcing it to trade what’s available at a given time.

Most every provider has a small-cap algo offering but you need to choose wisely because they differ greatly in performance. We hear some of the larger sell-side shops, such as Goldman Sachs, have been enjoying quite a bit of success recently after tweaking their particular models.

But not everyone can do small-cap as well as they can large-cap, so you need to have a different selection criteria. Agency broker Knight Capital’s MD Joe Wald, reckons small-cap algos are all about size discovery rather than price discovery.

That means shifting your paradigm, because size discovery – where you want to use the fewest venues as quietly as possible – is practically the opposite of price discovery – where you want to find as many venues as fast and as efficiently as possible.

That’s quite a different attitude to trading electronically. How do I select the right algo? 

First off, throw out all you think you know about smart order routing, because small-cap liquidity is not readily accessible and the stocks don’t trade frequently. Liquidity just won’t be spread across as many venues, so your algo needs to be very careful where it sends your order to minimise information leakage.

Wald says the top five things to watch out for are how the algo places the order, how it analyses venues, whether the broker has internal liquidity, how good is the anti-gaming logic, and how transparent is the liquidity-seeking.

And it seems small-cap popularity isn’t going away any time soon, so liquidity could become even more scarce, making algo choice all the more important. Wald says in 2010, Knight’s specialist small-cap Oasis algo saw notional trading of US$11 billion – and that more than doubled in 2011 to US$25 billion. So if you’re not already on the small-cap bandwagon, where exactly are you finding your big returns?

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