To create jobs, the stock market needs a little inefficiency

November 11, 2013: 1:51 PM ET

The stock market has gotten too efficient for small caps to thrive, and it's costing America jobs. But there is a solution.

By Scott Kupor

FORTUNE -- As Americans, we love efficiency. In huge numbers, and with our wallets wide open, we rush toward anything that drives lower cost, highly liquid markets. Think about it. McDonald's, Amazon and Costco dominate their industries with some combination of huge choice, overall lower prices and massive volume.

At scale, efficient markets can be great. Consumers get more for less, and producers profit from the combination of high volume at low cost. And efficiency begets even more efficiency – producers re-invest their profits to develop new products and to continue to lower production costs while consumer choice expands.

But sometimes the drive for efficiency goes too far. Particularly when that efficiency leads to complexity and hidden costs.

Such is the case with the trading market for small cap stocks – shares of companies with a market value of less than $750 million. The proverbial dog has caught the efficiency bus, only to find the wheels are falling off. The small cap market needs less efficiency – about a nickel's worth – and more simplicity along with it. Without it, the market that has historically created jobs, developed break-through technologies and rewarded investors with stock price appreciation will seize up for good.

Mistakes were made

Before we get to that nickel, how did we get here?

A series of changes in the US equities markets since the mid-1990's – electronic trading, order handling, pricing and trading rules, and decimalization – have in fact led to lower transactions costs for investors.

As a result, the US equities market as a whole is a highly efficient, liquid market.

Look no further than the rise of high frequency trading and other algorithm-based strategies that account for as much as 70% of total trading volume. These strategies make complete sense in a liquid market. Where you have low transaction costs and sub-penny spreads, traders can still earn profits with rapid, high-volume trading.

But not all stocks are created equally. While large cap stocks benefit from an environment that supports their trading liquidity – notably, broad research coverage from analysts and investment banks, and sales desks that facilitate large trades with market-making institutional investors – many small cap stocks are practically invisible.

As the march toward efficiency has increased complexity and shrunk margins to sub-penny increments, all of these liquidity-enhancing resources have been re-directed to high volume, large cap trading opportunities. Even more importantly, the mutual find industry, which manages $5.2 trillion of investments in equities on behalf of individual investors, has all but abandoned the small cap universe due to the complexity and fragmentation of the current market structure.

As a result, the small cap trading market is anything but liquid. Consider:

  • The average small cap company has only two research analysts, compared with 12 for large caps. Fully 29% of small caps have no analyst coverage (vs. 1% for larger caps).
  • Small cap average daily trading volumes as a percentage of total stock float – the best proxy for a stock's liquidity – are 40% less than that of large caps.
  • As a result, institutional investors comprise only 27% of small cap shareholders, compared with 81% for larger caps.

It's the jobs, stupid

Why is putting liquidity back into the small cap market vitally important? Simply put, it's because jobs hang in the balance.

Until the last decade, about 300 start-up companies went public each year, with more than half of those companies being small cap IPOs. Fast-forward to the most recent decade, and fewer than 100 companies each year have gone public, with less than one-third of those being small cap IPOs.

According to the Kauffman Foundation, small caps increase their post-IPO hiring by 156%. As a result, the small cap IPO doldrums have cost us an estimated 1.9 million new jobs.

RELATED: New bill to end decimalization for small-cap stocks

In addition to jobs, illiquidity in the small cap market is costing retail investors real money. Because institutional investors won't play in an illiquid market, individuals – who comprise 73% of the shareholder base of small caps – end up holding the bag. Illiquid stocks are less likely to be able to raise additional capital in the public market or use their stock as currency to fund acquisitions, compensate employees and compete for talent. This in turn hampers growth, ultimately resulting in less stock price appreciation to the individual retail investor.

Increasing liquidity in small cap stocks not only would help the 73% of individual shareholders who are already in the market but, more significantly, it also would open up the market to broader mutual fund investment.

About 90% of mutual funds assets are owned by nearly half of American households, representing nearly one-quarter of all U.S. household wealth. Making the small cap market accessible to mutual funds today would open up a whole new opportunity for retirement asset appreciation for the 58 million US households who invest in mutual funds.

The solution

Which gets us back to that nickel, and how a little inefficiency could have a huge impact.

As part of the JOBS Act (passed last year), the SEC was asked to study the effects of decimalization on liquidity in the small cap market. To date, the SEC has held a series of public hearings on the topic but has not implemented any formal changes to the capital markets.

As co-chair of the Equity Capital Formation Task Force, I am calling on the SEC to implement a multi-year pilot program designed to demonstrate that increasing the trading increments for small cap stocks from $0.01 to $0.05 will, in fact, increase trading liquidity in these markets -- thus driving higher volumes of small cap IPOs, growing jobs and creating attractive investment opportunities for 58 million households.

No doubt market efficiency is a laudable goal, but not at the expense of simplicity, and not if it means the collapse of a market that holds the key to sustained U.S. job growth, economic development and technology breakthroughs.

Scott Kupor is the managing partner at Andreessen Horowitz, where he is responsible for all aspects of running the firm. Previously, he was VP/GM of Global Customer Support & Software-as-a-Service at Hewlett Packard. Follow Scott on Twitter, @skupor

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