Is execution risk the latest burden for small cap managers?

Last month I wrote about the structure of risk analysis and the manner in which optimisers and the risk models themselves coexist. I theorized that the rise in volatility was pushing portfolios closer to market cap biased benchmarks irrespective of manager conviction. This month I’ll want to examine the changes in a more simple risk measure, show that this cap drift exists, and question what this means for small cap managers in particular.

To demonstrate this effect, let’s consider the three U.S. indices most reflective of size -- the S&P500 Large Cap Index, the S&P400 Mid Cap Index, and the S&P600 Small Cap index -- and show how the trading profile for their underlying constituents has changed over the last year. For illustration purposes, I’ll examine the ability to trade $1Million in the constituents of these indices and the amount of time, on average, that a trade would take. We'll compare today to one year ago.

Days to Trade = Value of Trade / (Scalar x 20 Day Average Value Traded)

Where Scalar = a nominal value selected to model a zero market impact (e.g., 10%) and the Value Traded is Total Daily Volume x Closing Price *Based on market level at 2/2008

Now as we would expect, we see the average number of days to trade large caps far below that of mid caps and the same again for small caps. Don’t pay too much attention to the scale as this is directly related to the scalar selected in the formula above. But do pay attention to the one-year comparative levels as they reflect what we might not expect to see, i.e., a marked change in the time to trade within the small cap S&P600.

I have rebased the $1Million investment of February 2008 to a $550,000 investment today to reflect the general market movement over the last year, but whereas for the large- and mid-cap indices we see the average days as being unchanged, we can see a 50% increase in the average number of days to trade for the smaller capitalisation stocks. Looking further into the Market Cap quintiles of the S&P600 we see still further bias towards larger companies.

*Based on market level at 2/2008

Viewing this data further supports my belief that there is a general increase towards closer replication of the market cap biased benchmark indices. Furthermore, the increase in time to trade in any sizable volume combined with the increased volatility of the markets (see last month's blog entry) means that the execution risk of any position is probably the largest risk to account for right now for any small cap manager. All of this points towards current small cap holders maintaining their positions where possible (any margin/redemption call may overrule this) while nothing but the strongest conviction would tempt anyone into anything new.

Tell us: Are market characteristics dominating the way that you are managing your fund?

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