Intelligent Trading: A Competitive Advantage During Market Plunges

Bob Fahy

How has the Royce team of traders been dealing with the recent surge in volatility and plunge in stock prices?

Bob Fahy: We've found it important to stay calm and centered in markets that are fraught with turmoil. Whether it was the Russian default, Long Term Capital Management, post 9/11 or the financial crisis of 2008, we strive to maintain a level head in volatile markets.

Our investment style lends itself to calm, grounded decision making. While others may panic, Royce sees a silver lining in terms of buying opportunities. It helps knowing which brokers are providing the greatest amount of liquidity in each stock.

More often than not, the volume in small-cap stocks is relatively low, so entering or exiting a stock sometimes presents challenges. To that end, it is absolutely crucial knowing "where the bodies are buried" in order to trade effectively and efficiently.

When stocks plunge, as we have seen in recent weeks, we are presented with an opportunity to participate in a rare event. Much like Haley's comet, if you miss it, you may not get a second shot to see it.

What is unique about Royce's trading team?

John Lucas: Employee turnover is remarkably low at Royce, something you don't see at many other firms. Part of the low turnover is due to the fact that we are each trusted to execute orders appropriately and independently. We aren't pressured from the top, which allows us to patiently execute orders as we deem fit.

Having nearly 40 years of experience investing in smaller companies gives us a competitive advantage.It puts us at the center of trading activity. We are often the first call when a large block of stock needs to be traded or timely information is released to the marketplace.

Give us a broad-brush understanding of the role of the Royce trading desk.

Dan O'Byrne: We are a team of nine seasoned traders, and we are in a constant process of buying and selling the stocks identified by our investment staff for the portfolios of The Royce Funds.This involves over two thousand trades per month, dozens of currencies to exchange, and ownership of over 1,400 companies. As our investment universe has expanded literally around the world, there are more markets, languages, time zones and currencies to consider in every trade decision.

There are two key responsibilities for our trading operation: First and foremost, we work to execute orders for our portfolio managers with the greatest efficiency and least market impact possible.

Beyond specific trades, we also provide them with information onthe market activity generally . Disciplined and intelligent trading is an integral part of our investment process and one of our key competitive strengths.

How does trading in smaller companies differ from trading in large-cap companies?

Dan O'Byrne: Trading small-cap and micro-cap stocks is a very specialized practice and finding these stocks at the right price can be a critical contributor to return.

The work is time sensitive because stocks in this asset class often trade relatively thinly, so it's crucial to carefully manage how much and how often we trade a stock so as to not adversely affect the price.

When trading volume is low, a small-cap stock may not trade daily or even weekly, so at times it can take months to build or exit a full position. Large-caps, on the other hand, tend to be traded moment to moment.

What challenges do you face trading non-U.S. stocks?

John Lucas: In the U.S., we deal with one country, one currency and the majority of trading is electronic. When buying and selling elsewhere in the world, we trade in more than 30 different countries, each with its own unique set of regulations, commission structures and fees.

When buying a micro-cap stock, those with market capitalizations up to $500 million (USD) in Europe or Asia, for example, I have to watch the movement in both the stock price and the currency rate to ensure the market capitalization is in compliance at the time of purchase.

The challenge arises when Asia is trading overnight. In these instances, I tend to err on the side of caution and provide a very conservative or tight limit price to offset a possible adverse move in the currency rate. Plus the normal liquidity issues apply, so it might take days or weeks to complete the order. Knowing which broker to use helps significantly.

Describe the process flow of trading a stock

Dan O'Byrne: We have a custom, paperless trading system that was written in-house. It has two points of order entry, a Portfolio Manager Order Entry System and a Trader Order Entry System. This means that when a portfolio manager enters an order from his desktop, it goes directly to his destination trader. Each portfolio manager has a trader for listed and OTC stocks, though all of our traders are quite capable and do trade both. The trader typically figures out how the stock is trading and checks various information venues before choosing a broker.

Adding a broker to the ticket posts a pre-loaded commission, and the trader can send that order for execution without typing much in a matter of seconds. We have a very low error rate. Our next morning DTC confirm rate is 99.7% correct. DTC or Omgeo, as it is now known, has a great confirm enrichment database that we use to help us achieve this. All of the custodian bank information for settlement is attached to each trade confirm from a pre-established set of instructions at each broker and bank. This is particularly relevant for our foreign trades as State Street's network alone has 129 sub-custody destinations worldwide.

How has trading evolved over the years?

Bob Fahy: Years ago, the role of a buy-side trader was to gather and relay pertinent market information to portfolio managers as well as communicate with the sellside, i.e. relaying order flow and receiving execution reports. Back then, a much smaller percentage of time was spent actually executing trades, but in recent years that has changed due to several factors.

The introduction of Direct Market Access (DMA), algorithmic trading and crossing networks has taken a lot of the actual execution of orders from the hands of the sell-side, who are the brokers we deal with, and placed it back in the hands of the buyside, that is, us. As a result, the cost of execution—commissions paid to the sell side—has gone down dramatically.

With the evolution of alternative execution venues and the diminished need to go through a sell-side broker, the actual control over execution quality has shifted to the buy-side trader. In addition, there is less information leakage now that we don't have to tell the sell side what our intentions are, which is a very positive thing for our shareholders.

About our traders

Dan O'Byrne, Principal and Director of Trading at Royce & Associates, started with Royce in 1986, the tenth employee of the firm. He wore many hats when he first started and in 1987 began helping out on the trading desk. He traded full time until 2003, when he began running the desk. He manages the trading team at Royce, an experienced group of nine professionals with an average tenure of 21 years in the investment business and 11 years at Royce.

John Lucas has been with Royce for three years primarily trading non-U.S. stocks, and Bob Fahy has been with Royce for thirteen years.