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June 30, 2003

Quants in the Steel City

By Nina Mehta

Mellon Equity Associates, a quant shop where Marlene Walker Smith works as a senior equity trader, is increasingly moving toward more electronic trading.

The trading desk is executing more orders on ECNs. "We've always embraced new technology, but ECNs have become even more important in the way we're trading these days," said Smith, who is a vice president at Mellon Equity. "We're probably trading in excess of 50 percent of our Nasdaq order flow on ECNs."

Founded in 1987, the Pittsburgh-based Mellon has some $14.4 billion in assets under management and 110 institutional clients. Mellon Equity Associates is one of Mellon Financial Corp.'s 16 asset managers.

The trading desk has five traders. This group trades all market caps and styles and works hand-in-hand with the portfolio managers. In addition to its 13 funds -active and passive, covering various styles and spanning all capitalizations - the firm manages a number of socially screened funds of U.S. equities.

Mellon Equity's proprietary 15-factor valuation model generates a score for each stock in its universe of 4,000 stocks. Trading decisions are made on the basis of the portfolio's characteristics and the model's scoring. The model, which has a 20-year history at Mellon, has been used for all funds since Mellon Equity was formed.

Mellon's trading philosophy has dramatically changed in recent years. The firm doesn't use much capital commitment now because of market volatility and decimalization.

Decimalization has reduced liquidity. As a result, orders are now typically broken into smaller pieces. "We try to find a natural [buyer or seller] that has traded the most volume in the name. We look under every rock for liquidity, using ITG's POSIT system, our main ECNs, which are Instinet and B-Trade, and others," said Smith.

The asset manager also uses Liquidnet and has started to tap direct access on the floor of exchanges in certain trading situations. If the firm can't find a natural, it goes to one of its regular brokers.

The make-up of the firm's broker list has also shifted. Orders are concentrated among the firm's top 10 to 15 brokers. At the same time, traders have considerable discretion over which broker they will trade with on each order.

Smith notes that, over the last two years, with the tightening of spreads, decimalization and the prominence of ECNs, the Nasdaq marketplace has improved.

"I tend to go to ECNs before I go to one of my brokers, especially for large names that I can trade just as easily as they can," she said. Smith adds that the firm's Nasdaq brokers add tremendous value in mid-cap and small-cap names because they see a lot of liquidity. The latter can be hard to find on an ECN, she said. However, if they're not a natural in a name she won't use them. "I'm not going to give up that information and I'm going to pick away at an ECN until I find something natural," she said.

The goal of the trading desk is to minimize so-called implementation shortfall. The asset manager uses Plexus Group data for its benchmark, and has been a Plexus subscriber since the desk was formed in 1994. (The firm's trades went through the mothership's centralized trading desk until high trading costs convinced portfolio managers that they'd be better off implementing their ideas through in-house.)

Mellon Equity trades some ETFs - mainly the S&P 500 Spider and the S&P 400 Spider - in its passive accounts. It uses ETFs to equitize cash in active accounts. The firm trades index futures in similar situations, but no single-stock futures or options on ETFs. New products get added to the mix at the behest of portfolio managers.