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Small cap returns outperformed big caps by 5% every year from 2005 to 2015. Yet now, some players on the buy-side are gravely concerned about the future of mid- and small-cap equities.  With the rise of private equity, is the market under threat of a slow demise? 
When Microsoft went public in 1986, the company’s market capitalisation was just $500 million. When Facebook went public in 2012, its market cap was $100 billion. This discrepancy has led buy-side observers to question whether the small-cap market is dying out. According to Anthony Godonis, senior equity trader at Aberdeen Asset Management, the key issue may be how the buy-side adapts to the new environment. 
“It used to be the case that you’d start by going to a broker, but that’s hardly ever the case now,” said Godonis. “The bank sales trader may not be the most experienced person. If the order is over-shopped, it creates impact. We should start electronically. Instead of relying on blocks from the sell side, try the pools.”
The problem, Godonis says, is that when the buy side goes to the broker, it moves the stock significantly. One solution to this problem is to use dark pools to reduce the market impact. Aberdeen Asset Management experienced lower market impact on trades that were executed electronically. But even then, the role of services provided by brokers can be an issue. “It’s the routing that’s the problem,” added Godonis. “Too much routing to a particular venue for example, will alert the HFTs where we are.” 
Old assumptions no-longer hold true either. Traditionally, many asset managers had grown used to the bundling of research and payments for execution. This used to mean firms that provided a good service in one area, such as research, were assumed to be competent in the other, i.e. execution. Yet this is now not necessarily the case. 
“Trading research providers used to be high quality trading shops,” said Godonis. “It’s not the case anymore. Great research doesn’t mean you should necessarily trade with the same broker.”
Unbundling is reducing costs, but at the same time, sell-side data costs are increasing. Aberdeen Asset Management reports that the sell side has not increased its charges to take account of that rise; instead, brokers are absorbing it by cutting costs internally. Meanwhile, buy-side broker lists are shrinking as buy-side firms themselves downsize their trading desks. There are concerns on the buy side about what impact all this cost-cutting activity this will have on the viability of sell-side services. 
“You can’t keep driving commissions down and expect the same quality of service from the sell side,” said Godonis. “Eventually we will reach a point where there’s going to have to be a new understanding, which says that if you want small and mid cap liquidity, you are going to have to pay for it.”
This is particularly important from a best-execution standpoint, because Godonis reports the brokers that tend to pay the most for market data tend to deliver the best results in terms of minimising market impact. In addition, the emphasis on cost-cutting means that some smaller brokers white-label smart order routing technology from larger firms, but in that case the buy-side trader may end up paying a larger fee than if they had just gone to the original broker behind the technology. It is always worth checking this first when using a local broker, he says. 
The quality of sell-side research is another problem for the buy side, since Godonis feels that it is not always of the highest quality. The issue is exacerbated by the low levels of revenue available for the sell side in this area and the consolidation of broker lists. Some analysts are crossing over to the buy side, he says – a strategy which may make sense, given that he believes the active managers that will prosper are the ones that do the research themselves. 
A related problem is the scarcity of block liquidity. “We’ve tried many times to incentivise brokers to offer larger sizes, but often we’ve found the market moves against you,” he added. “It’s hard to incentivise them to offer blocks. On the exchange side, the lit markets are OK because of all the passive trading. The exchanges own the auctions, so it’s doubtful they will push for many changes.”
This leaves the question of where to turn for liquidity. Aberdeen Asset Management supports IEX, the US alternative trading platform that recently became an exchange. IEX is best known for its system of “speed bumps” – random delays that are intended to prevent HFTs from gaining an advantage over other participants. 
The decision of US regulator the SEC to grant the venue exchange status was controversial. The main opposition to IEX’s application to become an exchange was based on the argument that no other exchange is permitted to introduce speed bumps, thus giving IEX a potential unfair advantage. Nasdaq has threatened legal action over the decision. However, the venue has gained popularity among the buy side.
One of the factors in favour of IEX is buy-side frustration with HFT. Most asset managers will acknowledge these days that not all HFT is bad, but many still find it frustrating they are making profits from the market when they have no interest in holding stocks for more than a few seconds or less. Long-only asset managers are typically holding stocks that are deciding people’s pensions over a period of 20 years or more.  
“IEX has instituted fairness in the exchange,” said Godonis. “The tools they have make sense. They educated a lot of people. This has pushed the regulators to look at the issues again. I think it’s changing things. IEX is doing things that feel right. And they’re eating someone’s revenue – you can see that from the level of furore they’ve generated in certain parts of the market. I think that’s a good thing.”
Perhaps the most pertinent question now is what happens if IEX can get into the big listings business, Godonis suggests. “Competition is good and I’m sure that IEX would provide a lot more disclosure versus other exchanges.”
However, the listings business may have serious problems that even a new platform might struggle with.  One of the issues is the lack of public market confidence. The growth in private equity means that companies don’t necessarily need to go public. At the same time, the very fact that there is the alternative of private equity means that there is less money in the market. “They feel they are better off making use of private equity. I don’t know what exchanges can do about that,” said Godonis. 

“Trading research providers used to be high quality trading shops, It’s not the case anymore. Great research doesn’t mean you should necessarily trade with the same broker.”

“IEX has instituted fairness in the exchange,” said Godonis. “The tools they have make sense. They educated a lot of people. This has pushed the regulators to look at the issues again. I think it’s changing things.”

Less is more?

Anthony Godonis, head of trading - Americas at Aberdeen Asset Management

Elliott Holley
Head of Global Buy-side Research
+44(0)7759 476779

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