For an institutional equities trader, liquidity in Bank of America, Apple, Ford, Pfizer or Google presents itself like a large lake off the backyard: it’s clearly there and easy to get to, and it holds a substantial quantity.
But it’s a different story when you get down to American Eagle Outfitters, Grubhub, Merrimack Pharmaceuticals and Beazer Homes USA. For mid-cap names such as these — and their small-cap cousins — there may be a lake, but it will be small and shallow. For significant liquidity needs, alternative sources are indicated — ponds and streams, bay and lagoons, tidal pools and even underground waterways. These alternatives can be far-flung, difficult to find, and laborious to access.
In other words, a trader looking for the other side of a large mid- or small-cap buy or sell order needs to pull out all the stops.
“You have to unearth that liquidity,” said Jay Biancamano, head of equities product marketing for the Americas at Fidessa, a provider of trading technology.
Block trading below the largest six or eight dozen names in the stock market requires “unique liquidity that you’re probably not going to find in traditional dark pools, and certainly not in the lit markets,” Biancamano said.
According to Biancamano, fewer than 10% of small- and mid-cap block orders have a ‘natural’ contra, i.e. a counterparty in the market to buy what you’re selling or sell what you’re buying. Buy-side investment managers can access dark pools for those transactions, but for the other 90% of market liquidity, it comes down to relying on the sell side’s earth-moving capabilities.
The effort can be worthwhile because alpha, or excess return, is perceived to be more abundant in smaller stocks. Facebook, General Electric and other mega-cap stocks are the market’s most liquid, but they’re also the market’s most researched and studied, both on their fundamentals and on their technical trading patterns. The crowds in these trades make it more difficult for an active investor to gain an advantage via stock selection.
“Portfolio managers are not going to differentiate themselves by trading the typical top 20 or 50 or 100 names,” Biancamano said. “There’s an increase in trying to find something further up the liquidity spectrum, the small- to mid-cap names.”
By way of background, the difficulty in sourcing small- and mid-cap block liquidity has to do with a very large universe, and a comparatively small float for each issue. That has been exacerbated over the past 10-15 years by a proliferation of trading venues and a resultant dispersion of liquidity.
“The buy side is looking for more and more liquidity in small and mid caps,” said Josh DiMarzo, head of trading at Weeden & Co., an equity and equity derivatives broker. “People are still frustrated — people are always wanting bigger size to trade in one block, rather than that that block being in multiple pieces.”
“Although markets have rapidly shifted from manual to electronic over the last decade, the progression to locate liquidity in thinly traded stocks has not,” said Craig Viani of Liquidnet’s execution and quantitative services group. “Buy-side traders still look to build institutional-sized positions from the ‘blocks down’. With little liquidity provided via capital commitment and less aggregated liquidity on physical trading floors, traders now rely on intelligent tools to help them navigate the markets.”
“As a result, many liquidity-seeking algorithms today are designed to uncover blocks by exposing orders to the dark pools most frequented by institutions,” Viani said. “But possession is nine-tenths of the law, and an algorithm is usually only as good as the block liquidity it sources internally where the broker can impose the most controls. When it comes to block-hunting in small- and mid-cap stocks, ‘neutral’ aggregation isn’t enough.”
Viani noted that some brokers are developing technologies that are meant to supplement, if not replace, what was exclusively the domain of high-touch traders. “With sell-side coverage devolving into an HMO-like service where the volume of patients supersedes quality care, trustworthy technologies with simple access to deep liquidity are ripe to supplant the expiring high-touch model.”
Biancamano of Fidessa noted that outside of the natural contra situations, procurement of small- and mid-cap block liquidity entails a series of steps. These can include combing through historical data and current holdings, keeping tabs on buy/sell interest via client ‘watchlists’, and using market intelligence, or ‘color’ to draw out prospective buyers or sellers. This process is being automated via technology.
Actively endeavoring to unearth liquidity “is as opposed to just saying, ‘Hey I’m a buyer, there’s a seller in the market”, because that’s not the case as you get down to the small- to mid-cap names,” Biancamano added. “That’s where the manual process comes in and where the high-touch trader adds a lot of value.”
With assistance from John D’Antona
Previously in this series:
With Julien Messias, Founder, Head of Research & Development, Quantology Capital Management
Retired buy-side trader survived the "hey honey, give me one of the traders" era.
With Alastair Clarke, European Equity Trader, Capital Group
The partnership simplifies institutional access to crypto markets.
With Ako Nishi, Executive Director, Central Dealing, J.P. Morgan Asset Management