Tick-size pilot program could help small caps

The SEC's proposed tick-size pilot program targeting small-cap stocks should lead to improved access to capital for small companies, sources say, but whether that translates to higher returns for institutional small-cap investors is less clear.

The proposed one-year program, announced by the Securities and Exchange Commission and created by the Financial Industry Regulatory Authority and national securities exchanges like the New York Stock Exchange, awaits a decision by the full commission before implementing.

It would divide stocks of firms with market capitalizations of up to $5 billion into a control group that would trade small-cap shares at any price increment currently permitted and three test groups using 5-cent trading increments: one exclusively trading at 5 cents; one allowing some shares under certain order agreements to trade at any price increment currently permitted; and the third subject to a “trade-at” requirement that prevents price matching by a trading center that is not displaying the best bid or offer. No date has been set for an SEC vote on the proposal.

“For large investors dealing in blocks, in theory there'll be more liquidity in the market with a wider spread,” said Brian Schwieger, head of equities, London Stock Exchange Group, London. “That would absolutely benefit the manager and asset owner. That's the theory.”

“If you're widening the tick spread, you're trying to find the right balance between the cost of investing and making sure the liquidity providers are incentivized where needed,” Mr. Schwieger said. “When spreads widen, there's typically larger trade sizes and larger volume per trade, but at the same time, there could be a reduction in the number of trades. It's easier to find blocks, which is great news for the larger investor. Wider spreads mean more stable prices.”

The pilot program's focus on increased liquidity will benefit small-cap investors because “they'll be more confident that you can get out of there when you want and at the right price,” said Kevin McPartland, principal and head of market structure research at Greenwich Associates, Darien, Conn. “There's not a lot of liquidity in small-cap trading. Why that is, is uncertain. Is it because there aren't enough market makers to get good pricing? Or is it that there's not enough demand for small-cap issues? Is it hard to get in and out of small caps at the right price? ... If asset owners are looking at a stock and this test shows improved liquidity, then it will make more of an impact in a good way on small-cap investing.”

But David Klaskin, founder, CEO and chief investment officer of small-cap equity manager Oak Ridge Investments LLC, Chicago, sees a tick-size increase as having no positive impact on his firm's investment returns. “Pennies are good,” Mr. Klaskin said. “It's a good thing to have tighter spreads. I need to access size. I think this could hinder what I do. Five-cent-wide margins aren't going to help.” Oak Ridge had $4.4 billion in assets under management as of June 30, the majority in small-cap growth.

The SEC's proposed plan is in response to a congressional mandate through the April 2012 Jumpstart Our Business Startups, or JOBS, Act, which required the SEC to produce ways to increase access for smaller companies to capital markets. Initial public offerings for companies with market caps of $5 billion or less totaled 199 in 2013, up from 41 in 2008 but still below the 240 in 2007 before the financial crisis, according to data from Dealogic PLC, London.

“The JOBS Act sailed through Congress. Who doesn't want to improve job growth? Small caps are the engine in the U.S. that builds jobs,” said Andrew M. Brooks, Baltimore-based vice president and head of U.S. equity trading at T. Rowe Price Associates Inc. Mr. Brooks said small-company launches were reduced because of the effects of regulations like the Volcker rule banning proprietary trading by banks, and also because of what Mr. Brooks called the “2008 malaise.” As a result, “a lot of little companies aren't able to become big companies. (The U.S.) is threatening our seed corn. What grows jobs are small companies, and if there are few small companies starting, there's not much planting.”

Oak Ridge's Mr. Klaskin concedes that the pilot program could lead to more smaller company launches, but he thinks more volume in small caps comes “when markets do well, not when spreads are wider.”

Mr. Brooks said that while it's unclear that there will be a direct connection between the pilot program and higher returns for investors, he's all for trying. T. Rowe Price managed $23.2 billion in U.S. institutional tax-exempt assets in small-cap equities as of Dec. 31, according to Pensions & Investments data.

“Whether (the pilot program) will show an increased return on the Russell 2000 (small-cap index), I don't know the answer to that,” Mr. Brooks said. “If wider spreads means increased transparency and displayed liquidity, that would be a good outcome. If the wider spreads would mean more attention, more incentive for small companies to tell their story, that would be a great outcome. If more people know about these firms, and there's more opportunity to trade; that will reduce trading costs because there will be more volume.”

Christopher Nagy, founder and CEO of market structure research firm KOR Group LLC, Omaha, Neb., said he thinks the pilot program actually has only two tracks, one with widening spreads. “I was disappointed,” Mr. Nagy said. “There'll be more dark trading, same as now, but the trade-at proposal is really good since that will get more small-cap shares traded on lit exchanges; right now, 40% of shares are in dark pools. The SEC should have looked at execution fees. I'm disappointed that we haven't seen anything from the SEC in that regard.”

Steven Glass, president and CEO at Zeno Consulting Group LLC, Washington, said the SEC pilot program takes a smart approach and isn't a knee-jerk reaction to the small-cap trading issue. “The pilot, to me, is a great example of where more analysis and assessment are needed,” Mr. Glass said. “I'm glad to see the SEC considering all possibilities here. I don't think you want to do something that could end up hurting more than helping. There are a lot of test cases; the SEC's plan is very thorough. What pension fund investors need to do is to solicit the views of their asset managers on this. There's no uniformity in thought on this.”

T. Rowe Price's Mr. Brooks is all for getting the pilot program started. “Let's try, let's experiment, let's crunch the numbers,” Mr. Brooks said. “This could work. We think it's worth trying. The JOBS Act was passed two years ago, and we still don't have a pilot program in place yet. Let's get it started and see how it'll work.”

However, Mr. Klaskin at Oak Ridge said institutional investors would be better served if the SEC concentrated on reining in high-frequency traders. “Anything they can do to limit the impact of that trading on block trades is definitely beneficial for institutional money managers,” he said.