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May 10, 2006

Finding a Small-Cap Strategy

By Nina Mehta

For small-cap traders, often wrestling with illiquid names, the advent of private crossing networks has been a godsend. That has certainly been the case for John Despotopulos. The head trader of Lee Munder Capital Group, a small-cap manager with $2.5 billion under management, has seen a surge in his desk's use of electronic trading.

In each of the last two years, 40 percent of Lee Munder's order flow has gone through electronic systems, both crossing systems and DMA. Three years ago the figure was 20 percent. With more buyside firms trading electronically, Despotopulos notes, liquidity in small-caps has increased on crossing networks.

"We're always trying to find the other side of a trade in order to reduce the impact," Despotopulos says, "and when there's more liquidity in these systems, we don't have to make that outgoing call to a broker. We can stay anonymous."

Despotopulos, a Lee Munder staffer since September 2000, began his financial career in the back-office of All-America Financial in Worcester, Mass. The buysider traded REITs at AEW Capital Management before moving to straight equities at Lee Munder.

The Boston-based Lee Munder uses Liquidnet, ITG/Posit and Pipeline. Liquidnet has been among the desk's top five brokers for the last two years.

"If you can trade with Liquidnet before going into the marketplace, before showing your hand to anyone else, that reduces the impact right there and lowers the overall execution costs," Despotopulos says.

At the same time that his three-man desk was embracing crossing systems, it was cutting back on its broker list. That's notable because firms that trade small-caps typically have large lists. In addition to the largest Wall Street brokers, Lee Munder uses a range of third-market and regional firms, as well as brokers that have heavy retail flow.

Last year Lee Munder's list included 100 firms, with the top 40 accounting for 90 percent of the volume. In 2004, the desk had relationships with 120 brokers. The top 50 brokers did 90 percent of the volume. Two reasons are behind the consolidation. First, commission rates are falling. And as research remains critical for small-caps, Lee Munder decided to concentrate its trading in order to be more important to the brokers it values most. "We need to get the calls we require from a research and flows standpoint," Despotopulos explains.

The other reason reflects a broader industry trend. "That's where the flow of our stocks has gone. Those top 40 are the more active brokers," Despotopulos says. "It's more of an industry consolidation than a Lee Munder consolidation," he adds.

Whenever possible Despotopulos and his colleagues trade with the research firm that provided the portfolio managers with the trade ideas. When they need to trade elsewhere to obtain best execution, they use stepouts. The firm also has a commission-sharing program with Lava Trading that enables it to pay independent research providers through Lava's sponsoring brokers.

"Relationships and communication remain key," says Despotopulos. "For small cap trading, we simply need the flow of information."

Lee Munder Capital Group Equity AUM: $2.5 billion Desk: 3 Traders Broker List: 100 Firms Avg. Comm.: 2.9 cents OMS: Eze Castle Software Trade Cost Analysis: In-House