Trading

Market participants call small-cap tick pilot disappointing

So far, not so good. Early reviews of the Securities and Exchange Commission's small-cap equity tick-size pilot program have been generally negative in regard to its impact on trading costs and investment returns.

“I don't want to be cynical, but I just don't see any benefit,” said Jason Valdez, New York-based managing director and global head of equity trading at Penserra Securities LLC. With all the time and effort that went into building (the test), it's turned into a huge D.O.A.”

For investors, “I would say the tick pilot hasn't helped,” said Philip Pearson, director, algorithmic trading, Investment Technology Group Inc., New York.

The SEC began the two-year program in October, in hopes of increasing investment and liquidity in small-capitalization stocks. The agency created a control group of about 1,400 small-cap stocks trading at the current 1-cent increment and three test groups, each with 400 stocks: one with stocks quoted in 5-cent increments but allowed to trade at current price increments; one with stocks quoted and traded at 5-cent increments, with certain exceptions; and one with 5-cent quotes and trades and a “trade-at” requirement to prevent price-matching by a trading center not displaying the best bid or offer.

In a report by ITG in January, early results showed the increased spread sizes mandated for some groups in the test have driven up trading costs despite the increased national best bid or offer sizes, and parent order costs of implementation shortfall — the difference between the price when a decision to trade is made and when it is executed — are 50% higher for the three test groups than before the pilot.

At T. Rowe Price Group Inc., the issue with the pilot so far hasn't been with returns but with turnover — or lack thereof, said Mehmet Kinak, Baltimore-based vice president and head of global equity market structure and electronic trading. T. Rowe Price managed $76 billion in small-cap equity assets as of Dec. 31.

“The biggest thing for us is the turnover we need,” said Mr. Kinak, who also serves on the SEC's Equity Market Structure Committee. “The more turnover in those names, the more natural liquidity. As a small-cap manager, we do the research, but I'm looking for other institutions and money managers who are making similar or contrary decisions to ours so we can get turnover and find each other in the market. That I haven't seen. We'd like to get more fundamental names and less passive ownership.”

Mr. Kinak said small-cap trading volume and trade sizes have been small since the pilot began. “The original intent was that with more market-making and more research (generated through the pilot), there'd be more volume and turnover,” Mr. Kinak said. “We haven't seen that.”

Small-cap stocks have seen a surge in returns over most of the pilot time period, but Messrs. Kinat and Pearson said that's more because of the election of Donald Trump and is correlated more with the overall rise in U.S. markets.

“I find it hard to believe that any of that increase is due to the tick pilot,” said Mr. Pearson.

Total returns of the Russell 2000 small-cap equity index bear this out. While the index has risen 11.2% from pilot inception on Oct. 1 through March 6, it was down 4.41% from Oct. 1 to Election Day Nov. 8 and then rose 16.34% from Nov. 9 to March 6.

The bigger impact for small-cap money managers, said Mr. Pearson, is the increase in trading costs. “Trading costs (for small-cap stocks) are up 15%. Research shows the cost of the pilot vs. the control group is the cause, so it's 15% above any rise in costs for small-cap trading anyway,” he said. “(Managers) have probably added that into their models. But for returns, there's not a major impact.”

Mr. Kinak at T. Rowe Price said the 15% cost increase is “a function” of lower passive investment fill rates. “Institutions can't sit on a bid as long as a market-maker can. When we get an order, we have to trade.”

Higher trading costs

At Dimensional Fund Advisors, Dave Twardowski, Los Angeles-based vice president-trading research, said the early days of the tick pilot haven't changed firm executives' thinking from when it was first proposed in 2014.

“We do not think that forcing investors to trade at wider spreads will increase the number of new listings,” Mr. Twardowski said. “We expected, and have observed to date, higher trading costs for investors in the market after the tick pilot. If the goal of the pilot is to increase the number of (initial public offerings), we believe that efforts could be better spent by studying the root cause of why there have been less IPOs in recent years.” Dimensional managed $87 billion in small-cap assets as of Dec. 31.

Penserra's Mr. Valdez said, in theory, the pilot's intent of helping small business develop and create jobs “was what should have happened, but it certainly hasn't generated those. Generally with more liquidity, there's more participants, and that should improve the market. If there's super-liquidity with a larger market, that would normally bring spreads down. But this test is widening the spread. All that order flow and liquidity was supposed to help, but so far, volume is down and costs are up. People aren't finding the liquidity they thought they would.”

“People in the industry are asking: Are you doing more harm than good with this test?” Mr. Valdez said. “There's no evidence that this is creating jobs — the only jobs it's created are IT jobs at financial firms.”

The SEC could decide to stop the pilot before the expected October 2018 end date, particularly with Jay Clayton, Mr. Trump's nominee for SEC chairman, leading the agency, Mr. Valdez said. “You would think that even before the new administration came in, the tick pilot was already on the rocks. If they come in and start slashing budgets, they'll probably cut bait” on the pilot.

Mr. Kinak disagreed. “I don't know why you'd pull the plug early. There's no real detriment to continuing,” he said. “The No. 1 reason to keep going is jobs. You'll have to see if making markets will create a decent profit. That's a long-term approach — more small caps, more on the secondary market, leading to more hiring. That's a turnover function and a research function. If you want to build a firm, you have to get your name out there. That takes time.”