So what now?
With sources saying the current tick-size pilot program by the Securities and Exchange Commission for small-cap stocks has not improved liquidity in the asset class, some are wondering if there are other ways to increase liquidity and make it easier for small-cap investors to actively trade.
"The tick pilot isn't working," said Richard Johnson, vice president, market structure and technology, at Greenwich Associates, Stamford, Conn. "There are some who just think they should cancel it now. There's even a question as to whether there is a problem with small companies. They're absolutely harder to trade than large caps, but the greater returns factor into the higher cost of liquidity."
The effort by the SEC to help make an inefficient market like small-cap equities more efficient by increasing tick sizes to 5-cent increments from 1 cent emphasizes a central premise for small-cap investors, said Ryan Larson, head of U.S. equity trading at RBC Global Asset Management (U.S.) Inc., Chicago. "The tick pilot was never created to facilitate active small-cap management. Regardless of the outcome of the pilot, which to date doesn't seem like it's proving to meet initial expectations, the value proposition for active management in less efficient areas of the market remains very strong."
The tick pilot, which began in October and extends through October 2018, has not resulted in an increase in the number of listed small-company stocks, as was hoped, but it hasn't hurt small-cap stock performance so far. Through the 12 months ended April 30, the Russell 2000 index has returned 25.6%. But Adam Sussman, senior adviser, head of market structure and liquidity partnerships, at Liquidnet Inc., New York, said a more robust listing market for small caps would create "new ways for active small-cap managers to set themselves apart from the index and outperform it. As the number of small-cap companies decrease, it's tougher to do that."
The reduction in small-cap equity listings is a large part of the global phenomenon of fewer listed stocks over the last 15 years, Mr. Johnson said, to around 4,000 currently from 8,000 publicly traded companies in 2002.
"We're looking at more companies not going public at all," said Mr. Sussman, "How do you fix that?"
Messrs. Johnson and Sussman agreed that increasing the number of listed small-cap companies could happen two ways — through easier SEC guidelines for exchanges to list those companies, and toughening tax rules on carried interest to make going private more onerous.
"Investors like pension funds are limited in many cases to invest only in public companies," Mr. Johnson said. "Venture capital and private equity have more capabilities for fundraising and (the companies) never make it to the public market. They're more attractive because of limits on going public (such as Sarbanes-Oxley regulations that require listing firms to conduct expensive internal audits), and with so much capital going into private equity and venture capital, there's often no need to go to the public markets. There's also a lot of smaller companies in mergers and acquisitions, where large firms are buying up smaller firms, so that, plus private equity and venture capital, make it tough for smaller companies going public, and by extension tougher for small-cap investors."
Mr. Sussman recommended "a combination of a carrot and a stick" approach. The carrot — make it less burdensome to become a venue to trade small caps — and the stick — increase requirements for private fundraising. "We should level the playing field by making rule changes for public as well as private fundraising," he said.
"The carrot is more likely," Mr. Sussman said. "The incoming SEC chairman (Jay Clayton) has said his goal is to make public listings more robust. The question is, will the SEC feel more compatible with the carrot and the stick. If you're in a deregulatory attitude, you'd think the carrot would come first."
He said under the current administration, deregulatory changes are more likely than adding new regulations to make it easier to file an IPO and harder to get private funding.
While the Illinois Municipal Retirement Fund, Oak Brook, does not have an opinion on any potential changes to public or private market regulations, its investment staff is aware of the impact lack of liquidity can have on small-cap investing, said Dhvani Shah, chief investment officer at the $38.2 billion pension fund.
"We definitely agree that in some instances, liquidity can become an issue for many investors," Ms. Shah said. "IMRF manages the liquidity issue in two primary ways. First, our exposure to the small- and microcap asset classes (about $3.2 billion and $500 million, respectively, as of April 30) is entirely actively managed … We are able to actively monitor these exposures and will manage the allocation weights as necessary."
Small-cap equity was 19.4% of Illinois Municipal's $16.5 billion domestic equity portfolio and microcap equity, 3.2%, both as of April 30.
For example, Ms. Shah said, as a result of IMRF's August 2015 domestic equity structure review, "we reduced our overweight to small caps by $525 million, or approximately 2% of total fund assets at the time. Secondly, IMRF's long-term investor profile means that we're able to be patient and methodical when contributing to, or trimming assets from, our underlying small-cap mandates."
That profile spurred IMRF's 21.9% return on its small-cap allocation for the 12 months ended April 30, vs. the Russell 2000's 25.6%, but since that portfolio's inception in July 1988, the pension fund has returned an annualized 12.5% vs. the benchmark's 9.6%.
While others said regulatory rather than market structure changes should be used to increase liquidity, Ms. Shah said there are other potential changes — specifically with technology advancement — that could bode well for small-cap investing.
"Although IMRF views the liquidity profile of small-cap equities to be a net positive for institutional investors like ourselves," Ms. Shah said, "we are certainly intrigued by the potential benefits technological advancement within back-office settlement could bring to the table. The efficacy of blockchain could garner much better price discovery on less liquid security types, while simultaneously reducing transaction costs and risks of trade fails. The more obvious benefit of same-day settlement and its knock-on effect of more efficient cash management is also very appealing to IMRF as an asset owner."