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August 14, 2007

Getting an Edge

Firms Make Moves to Add Value in the Less-Liquid Names

By John Hintze & Michael Scotti

Wall Street pros, if nothing else, are always in search of an edge. Whether it's money managers looking to boost their returns for investors or brokers seeking to offer new or better services to their clients, the Street has always been a hotbed of innovation and competition.

Two firms-one sellside, one buyside-are staking a claim in the less-liquid names, in an effort to bring greater value to their clients. Jefferies & Co. has undergone a mini-transformation of its business model and is looking to commit more capital than it has in the past for small- and mid-cap stocks.

Meanwhile, Putnam Investments has reorganized its desk along the lines of liquidity characteristics, allowing traders to focus and specialize on the various market-cap segments.

At the same time, the environment for trading less-liquid names in the mid- and small-cap segments is evolving, with traders reporting that they are having more luck executing with algorithms than in the past. These algorithms stealthily access dark pools without tipping an investor's hand, but they can also be more aggressive, depending on a trader's strategy. Buyside traders contacted for this story say they are now electronically executing anywhere from 10 to 50 percent of their small-cap flow.

Venue Choices

That figure encompasses all electronic trading, including crossing, algos and traditional direct market access, whereby a trader posts orders and can submit hidden reserves. The latter remains an important part of small-cap trading. The same is true for independent crossing networks, like Liquidnet, Pipeline and ITG's Posit, that can print size. With the increase in liquidity in numerous dark pools, traders say a symbiotic relationship between algorithms and dark pools has emerged, and that the lines distinguishing one from the other are beginning to blur. In the end, they say, it doesn't matter where they trade, as long they can do so without market impact and avoid leakage of their intentions into the marketplace.

John Despotopulos, head trader at small-cap manager Lee Munder Investments, which has about $4 billion in equities, says he became convinced in the last year that he could effectively use algorithms for less-liquid stocks. "The intelligence behind algos has allowed them to better handle small-cap stocks, and they've gotten a lot smarter," he says. About half of Despotopulos' desk's order flow is executed high touch, while about 10 percent is executed in dark pools, mostly via algorithms. So how does a trader decide where to go with an order? "It's really a matter of knowing our stocks and who trades them," he says.

Tereck Fares, director of equity trading at Chicago Equity Partners, says he expects the trading of small caps in dark pools via algorithms to continue to grow. "The liquidity in the pools is deeper today than it was a year ago, and it will only get better," says Fares, whose firm manages $11 billion in equities.

Human Touch

Jefferies & Co. understands the buyside's evolving outlook and can see dark pools and algorithms getting better at executing the less-liquid stocks. But the firm also believes there's still a need for human traders to oversee the entire process.