Getting an Edge
Firms Make Moves to Add Value in the Less-Liquid Names
August 2007
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.
And if volatility should return to the marketplace, traders are likely to become even more important for small- and mid-cap stocks. To be sure, the CBOE Volatility Index, a measure of market expectations of near-term volatility, has been unusually low since 2003, despite some shifts here and there.
But brokers and their institutional customers alike foresee the inevitable return of volatility, and some have taken steps to ready themselves.
Small- and mid-cap companies are generally defined as having market capitalizations between $300 million and $2 billion, and between $2 billion and $10 billion, respectively. Trades in some of these names have always been the hardest ones for which to find liquidity. Increased volatility would make that job that much harder.
Jefferies & Co., which does 75 percent of its business in the small- and mid-cap arena, has gone on a hiring spree in the last year, pulling over high-cost talent from competitors to ramp up its services in the realm of less-liquid stocks. A key criterion of those hires was whether the executives brought experience in committing capital-a significant change for Jefferies, which had been primarily an agency shop. "The new captains now running the sectors all have broad and deep capital-committing experience," says Ross Stevens, co-head of equities at Jefferies. Stevens joined the firm in November 2005 from Banc of America Securities, where he was chief operating officer for equities and the head of electronic trading services.
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