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Computer-driven investment firms are increasingly trading over-the-counter US stocks, attempting to bring modern algorithmic strategies to a realm traditionally seen as one of the riskiest corners of equity investing.
So-called quant hedge funds and proprietary traders are being drawn towards this corner of the market by a combination of improved liquidity and the increasing difficulty they face making money in the large-cap markets they have previously focus on, say investors, market makers and exchange executives.
“It’s sort of at the sweet spot of what an investor like us thinks we can do,” said Seth Weingram, senior vice-president at Acadian Asset Management, which specialises in systematic strategies and runs a microcap strategy that includes OTC stocks. “It’s the least efficient part of the equity universe, and we are really interested in less efficient market segments.”
Over-the-counter stocks are shares in companies that are not listed on mainstream exchanges such as the New York Stock Exchange or Nasdaq. More than 12,000 stocks trade on the US’s main over-the-counter network, which is operated by OTC Markets Group.
Those 12,000 companies range from dollar-denominated versions of big foreign stocks such as Nestlé, to smaller domestic groups drawn by cheaper listing costs, to highly speculative shell companies or bankrupt businesses that have been kicked off mainstream exchanges.
Earlier this month the Financial Times reported that traders had spent hundreds of millions of dollars on shares in defunct retailer Bed Bath & Beyond since it was delisted from Nasdaq in May, even though analysts consider it worthless and another company has bought the rights to its name.
While measuring quants’ share of trading in OTC stocks is difficult, hedge funds and proprietary traders account for a much bigger share of OTC Markets Group’s recent customer growth than in the past.
Such firms are still a relatively small part of the wider investment landscape, but made up 40 per cent of new customers paying for access to OTC Markets’ data over the past two years. In the first half of 2023, the percentage increased to 50 per cent.
“Anyone with a broker relationship can pick out single securities or specific situations they might want to trade, but once they’re buying the real-time data, it indicates they’re putting it into a larger programme or strategy,” said Matt Fuchs, OTC Markets executive vice-president for market data.
OTC markets used to be known as the “pink sheets”, named after the coloured paper on which quotes were published. They were popular with retail traders but expensive to trade and notoriously risky, and were prone to “pump and dump” scams.
In total, investors traded some $507bn worth of OTC stocks last year — down from the peak of the meme stock craze in 2021, but still more than 50 per cent higher than 2019.
The increased liquidity has made it easier for algorithmic strategies to work. Meanwhile, with most big fund firms still spurning the space, competition from other institutions remains low.
“Trading volumes are much, much smaller . . . there’s not as much competition as in traditional standard developed parts of the equity markets,” Weingram said.
The Composite index of OTC stocks has risen 45 per cent since the end of 2018, compared with 51 per cent for the S&P 500 and 49 per cent for the Russell 2000 small-cap index. However, proponents say there is more opportunity for active managers to add value in the smaller-cap space than in more efficient large-cap indices.
PGIM Quantitative Solutions, the systematic trading arm of the $1.3tn asset manager, started a quantitative microcap strategy last year. “In terms of adding [outperformance] we’ve seen much more opportunity compared to other strategies . . . it’s hard to add value if you’re benchmarked against the S&P 500,” said managing director and chief investment officer George N. Patterson.
PGIM is among firms that have been pitching such strategies to clients as an alternative asset class comparable to private equity, which can be used to diversify portfolios and reduce correlation with major markets.
However, some investors remain sceptical.
“You look at a company and ask is there value here or is it smoke and mirrors, and there’s more smoke and mirrors than value in the OTC market,” said Scott Sheridan, the chief executive of Tastytrade and co-founder of Thinkorswim, retail-focused options trading platforms.
He said while there was always the potential for a lottery ticket — an obscure stock that dramatically increases in value — that is rare, as it is for companies that trade OTC to grow and then list with regulated exchanges. “This isn’t like the minor leagues in baseball. There’s a reason these companies aren’t trading listed.”
“We have less than zero interest in OTC. There are so many pump and dumps,” Sheridan said. He added that there were risks for institutions, given the regulator environment. “With pink sheets, you’re asking for the regulators to come in and ask why you’re trading this.”
PGIM’s Patterson acknowledged investors still “have to be careful and pay attention to managing costs”, but insisted OTC was “not the same space it used to be 10 years ago”.
He added: “The risk is not outsized compared to, say, certain emerging markets strategies or lots in the hedge fund space. I think it’s a lot less risky than crypto.”
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