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February 1, 2005

A Highway to Execution Heaven

By Nina Mehta

Speed doesn't kill. Speed liberates, one buysider exalts. "I love the speed and finality of getting the transaction done. You go to buy 100,000 shares, you do 40,000 and spend the next three days working the 60,000 - and you're done," says Dan O'Byrne. "There's quick gratification."

O'Byrne is vice president of trading and administration at Royce & Associates, a small-cap asset manager with $22 billion under management. The desk, which manages 21 mutual funds, is a wholly-owned subsidiary of Legg Mason. The trading desk in New York supports five traders, as well as O'Byrne. Two specialize in listed stocks, the other three in OTC stocks. "Familiarity means a lot with small caps," says O'Byrne. About 60 percent of Royce's trades are in Nasdaq-listed stocks; about 40 percent in exchange-listed issues.

Royce's traders also execute for specific portfolio managers. "Our portfolio managers give us lists of orders with pretty strict limits," O'Byrne says. "The PMs know their stocks better than anybody, and the traders put those trades into play."

In his 18 years at Royce, O'Byrne has seen the trading landscape radically transformed. "But now, with the proliferation of ECNs [and electronic trading], a new kind of fragmentation has eked its way into the market," he says. O'Byrne say this isn't necessarily bad. It requires more pre-trade work, but the lack of consolidation can benefit the execution of small caps. "We can sometimes pick up decent positions in thinly-traded names," says O'Byrne. "There's a lot of order flow on systems not hitting the aggregators, so you can spread your orders wide."

This also means a more crowded execution space. In the last two years, Royce has looked at eSpeed, Lightspeed, Pipeline, royalblue Fidessa, Neovest, Radical, Triton, Firefly, EdgeTrade and Flextrade.

The desk's main venues for OTC trades are Bloomberg's Tradebook, Sonic Financial, Liquidnet, Lava Trading and Instinet. "They're about the most techno we get on our orders," O'Byrne says. "The rest is negotiated trading." He adds that the holders of small-cap stocks tend to be as far-flung as small-cap companies. This means that there's often a retail broker in Seattle or Cincinnati dealing with the other side of the order. Royce uses up to 200 brokers a year, many of them regionals. That's a lengthy list for a money manager of its size. "We get better research out of those regional brokers covering our names and better trading coverage," O'Byrne says. "They can treat our orders with a more kid-glove attitude than the main offices of the big wirehouses."

Another recent shift that O'Byrne has witnessed involves capital commitment. "It's thinner than I've ever seen it by market makers," he says. Royce does about three percent of its OTC trades on a net basis now, versus about 30 percent three years ago. O'Byrne adds that this change has been spurred by decimalization.

Yet with all these changes, relationships remain critical - especially for small-cap and illiquid stocks. As Royce's trading desk has grown, the firm has gained a broader distribution of trading relationships. This translates into more choice. "We'll now know three traders at Merrill Lynch or Bear Stearns, for example. Trading is still very much a relationship business," says O'Byrne. However, relationships aren't infinitely flexible, especially as lower commission rates exert more pressure on brokerages. "You have to do more with your good relationships now," says O'Byrne. "Those brokers are making less than the 5 cents a share they were making a year ago. They need to work harder and do more volume, and you need to give more of it to them if they're doing a good job for you."