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August 31, 1998

Principal Blind Bidding In Portfolio Trading

By Special toTraders Magazine

Also in this article

  • Principal Blind Bidding In Portfolio Trading

Planning to bid for an institution's portfolio? A profitable way to utilize capital? Don't be fooled. Every year, broker dealers enter the business and soon quit when losses mount. Only the strongest survive. Among them is D.E. Shaw Securities, one of Wall Street's top principal portfolio-trading firms.

The New York-based broker-dealer subsidiary of D.E. Shaw & Co., which started trading portfolios as a principal in the early 1990s, now averages four principal trades daily, and this year handled one trade with a value of about $1 billion. (A typical principal portfolio trade is valued at only $50 million.)

D.E. Shaw Securities regularly bids "blindly," using quantitative trading technology. But, explains Mony Rueven, managing director in charge of portfolio trading and the firm's 30-strong U.S. institutional equity group, portfolio trading is not for amateurs.

Q: D. E. Shaw Securities is well known as a quant shop that employs mathematical models in trading. So why is it handling portfolios, or so-called equity baskets?

A: Trading portfolios on behalf of institutional clients fits in very well with our other dealing activities, where we make markets or provide liquidity in equities, convertible bonds, warrants and equity derivatives, both in the U.S. and overseas.

It is also a business in which our quantitative-trading and risk-management expertise gives us a clear competitive advantage. It is no secret that sophisticated institutional investors have analyzed their holdings as portfolios for a long time. Only in the last few years, however, has the buyside begun to see the often substantial benefits of trading lists, or portfolios, rather than individual positions.

D. E. Shaw Securities, for example, often provides institutional clients with analysis to help them decide how they should trade particular lists of stocks as a portfolio versus individual positions, as a principal versus agency positions, and so on.

The institution has a number of choices: principal basket trades, agency basket trades, incentive agency trades, basis trades and EFPs [exchange for physicals]. While they're sometimes used to satisfy special trading needs, institutional investors most commonly use basket trades to invest new cash flows, change asset allocation and rebalance portfolios.

Q:Let's focus on a principal basket trade. Provide an example.

A:Say a money manager is rebalancing his portfolio and has $50 million of equities to buy, and $50 million of equities to sell. He'd basically have two choices about how to execute this list. He could execute it conventionally, doling out individual trades on an agency basis to brokers. The brokers would work them on the floor of an exchange or on an electronic communications network.

Alternatively, the money manager could approach a firm like ours, which, without seeing the trades in the list, would bid for the entire portfolio as principal, offering to execute all of the component trades at market-closing prices for a flat, per-share commission. That's called blind bidding.

Q:How can you bid on a portfolio as principal if you don't know the positions it contains?

A:Here's how it works, mechanically: Every month or so, we provide our clients with a floppy disk containing the latest version of our proprietary portfolio-bidding software.