Part Three: Transitioning Small Caps- More Than Meets The Eye
(September 18, 2018) – Transition providers are always seeking to set themselves apart from the competition. In an industry where transparent business models, cutting edge technology, competitive pricing and white glove service are effective ways to differentiate, such selling points alone do not always guarantee a provider to stand out from the crowd, particularly when dealing with esoteric assets like those in the small cap equity space. Asset owners must be 100% comfortable in a provider’s ability to not only demonstrate their subject matter expertise, but be fully transparent in how they plan to execute a given trade. After all, different asset classes call for different execution styles. Simply having providers assure assets owners of orders being executed in a desired timeframe at the lowest commission rate possible would be far from a prudent approach.
Part Three of Penserra’s four-part series examining small cap stock trading highlights the subtleties of transitioning small caps, including the following variables all asset owners should consider when vetting a provider for small cap mandates.
A Matter of Time
Time plays a critical role when it comes to trade cost estimates and execution strategy for small caps. How long a provider is afforded to complete the actual transition trade will dictate their view on the opportunity to source liquidity. Inevitably, the set of choices made available to providers will come down to the asset owners’ urgency to complete the event.
Given the liquidity constraints of trading small caps, there are certainly good reasons as to why patience on the part of the asset owners can be prudent. For one, a hastily executed strategy can be unforgiving to the event’s cost and the asset owners long term returns. By having a constant presence of thinly-traded securities orders in the marketplace, the trade can be easily telegraphed and have an impact to the final prices and costs. Price pressures can be further exacerbated when constant probing for liquidity occurs using the same execution venues within a short period of time. Ideally, the more time a trade is given to be implemented, utilizing a multitude of venues, the less impact a provider should experience on security prices and implicit costs (a significant component of the total estimated trading costs with small cap trades). For asset owners, it is important to understand the relationship of time and how it drives in producing risk/cost estimates and a provider’s execution efforts.
Planning for Success
A well thought out implementation strategy will consider client needs, constraints, transaction costs and opportunity costs. While to a skilled provider of all these inputs to an optimal solution are important, we find that the transactions costs seem to play a very significant role in small cap events. The exclusive reliance on models is a common practice to establish a baseline and while it is more reliable for diversified portfolio transition events, it does pose some challenges for concentrated portfolios. Transaction cost modelling in small cap stocks requires additional layers of skill and experience. Generally, cost model calibrations are commonly designed around the premise of symmetric and constant liquidity profiles. When actual liquidity patterns deviate due to asymmetric liquidity profiles, models lose some of their predictive capabilities and lead in most cases to estimation challenges of execution costs for very illiquid stocks. The skill of a transition manager is to analyze costs of liquidity outlier on a stock by stock basis which leads to better cost and implementation timeframes estimates. Liquidity constraints can extend to the overall portfolio level by creating completion rate imbalances at the directional- (buy vs. sell), regional- (global trades) and sector-level leading to potentially undesired risk profile and potentially higher implementation costs.
No Substitution for Experienced Trading
Given the fragmentation of order flows that exist with small caps, the degree of proficiency to navigate across the various execution venues in search of liquidity can make a difference in the quality of execution and completion rate. By operating a highly effective trading workflow and communications process, which begins at a detailed analysis level and spans through to numerous trading decisions, a provider is able to demonstrate their experience level in evaluating the profile of a specific transition trade and skillfully detect and exploit any hidden pools of liquidity.
Targeted high touch trading strategies armed with direct human market intelligence also allow a provider to find a balance between delivering good benchmark performance and weighing the interests of the overall transition. These execution strategies are formulated to effectively address the specifications below, and then continuously adjust given existing market conditions;
- Decision points on when and where to enter the market
- Best way to disguise trade orders and remain in stealth mode
- Avoid establishing the going prices
- Best source to gather hard-to-find market information
Conclusion
As we work closely with experienced resources, a transition manager’s objective ultimately is to design a plan that will minimize costs, reduce risk, work around or remove constraints while delivering to clients what they need.
In a segment of the market where it doesn’t take much to adversely move prices and tip off competing market participants, it is imperative that asset owners choose a provider who:
- is fully transparent in what the costs and risks are given their expectations
- has a full appreciation of trading disciplines and dissemination of information
- has a solid background with a good track record
If you have any questions or wish to learn more about Penserra’s ability to transition and trade small-cap stocks, please contact Zlatko Martinic, CFA at zlatko.martinic@penserra.com or Jason Valdez at jason.valdez@penserra.com, or call 800-456-8850.
