October 27, 2009

Volatility and Small Caps

We’ll spend the bulk of today’s note explaining why small-cap stocks increasingly find their shareholdings dominated by a few large quantitative institutions.

First this on equity markets: Last week we noticed a surge in “volatility trading.” We’ve written before about these tactics that capitalize on volatility as the asset instead of the direction of the markets or a given security.

You should know about them because they’ll impact your price even if you trade less than 100,000 shares per day. We can find these things in market structure because certain firms specialize in it. When they show up, we watch what happens around them, thus discovering who else does it and what effect they have on market structure.

Under normal circumstances there wouldn’t be much. But we’ve woven such a tight risk-management net around algorithmic execution that everything reacts to everything else. Volatility traders who previously were using the VIX and similar measures perhaps have lately discovered that they can nudge risk-management algorithms around and produce volatility. It’s another unintended consequence of “systemic risk,” which can only exist when something artificially impedes natural failure.

Back to small caps. The average trade size in US markets today is less than 300 shares. We find in our pool that it’s closer to 200 shares. That’s partly due to the way the SEC measures “best execution,” or the quality of trades under SEC Rule 605. Broker-dealers must be within standard deviation of broad industry measures or they’re subject to fines. Naturally, over time executions become similar: about 186 shares per trade, regardless of market cap.

Say a multi-billion-dollar stock trades 26,000 times per day (and prices millions of times), while a stock with $500 million in market cap trades a thousand times. Both average 186 shares per trade.

A value institution is constrained by market structure from owning the smaller company. If they execute 100 trades, or 18,600 shares, high-frequency systems front-run and price them out of the market. Over time, the most efficient and compliant mechanism for owning small-caps are big risk-averse ETFs and algorithms cutting across hundreds or thousands of stocks, such as Renaissance Technologies or AXA or Dimensional Fund Advisors might run (through big prime brokers), or which Vanguard or Barclays iShares or Deutsche Bank Powershares might continually direct through their prime brokers and direct-market access channels.

Thus, small-caps become quant holdings. The problem is that small-caps and large caps alike need rational holders who stay the course through market swings and business cycles, the sort of thing that emotionless execution just won’t do.

This is a regulatory issue, IROs and execs. Structure is screening out your fundamental holders. How do we solve it? Speak up! Voice your opinion! Rules are supposed to create level playing fields, not advantage the dispassionate.

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