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April 21, 2005

High Tech at the Hedgies

By Peter Chapman

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Galper: It varies. It depends on the system. Everyone's technology is a bit different. With Instinet, yes, you pay Instinet. They pay other people at your direction. However, if you are on a Lava or a Sonic... I believe Sonic is developing this. With Lava, you actually select the broker to pay from a list of brokers. You are still making your own trade, but you are crediting one broker or another. That's who you ultimately pay.

Traders: OK.

Galper: When the trade is done, it goes through with the broker's pneumonic. So with Instinet, all trades are done with Instinet's pneumonic. But with the Lava set-up, the bill comes back to the hedge fund from all the different brokers. There are three models - one, you can trade under different brokers' pneumonics, two, step-outs or give-ups on the floor, and three, simply write a check.

Traders: Your report states that step-outs are widely disliked.

Galper: The hedge funds we spoke with do not care for step-outs because they are complicated. They are lukewarm on the Instinet model because they find it to be more costly.

Traders: Multi-broker routing is a big issue?

Galper: It's huge. We're actually coming out with a big report on it.

Traders: On to the algorithms. As funds get larger, they use algorithms more?

Galper: Well, it's tied more to volume than to size. Take a small fundamental fund, for instance. They're just not trading that much. Why would they use an algorithm? One person can handle it.

Traders: So the more volume they do, the more likely they will use algorithms?

Galper: Right and that's for reasons of efficiency.

Traders: The report states that hedge funds are more inclined to use algorithms than traditional money managers. How much more?

Galper: Our numbers show traditional long-only managers using algorithms for about five percent of their orders. That's orders, not volume. On the other hand, hedge funds are using algorithms for 10 percent of their orders.

Traders: That's broker-supplied algorithms as well as home-made?

Galper: These are broker algorithms only. With proprietary algorithms, it's a whole other story. That's when you enter into the world of the stat arb funds. These folks may have no experience with a broker algorithm at all. They've been writing their own for years and years. That's how they make money.

Traders: And the stat arbs may be doing 100 percent of their trading through their black boxes?

Galper: Exactly.

Traders: What is the breakdown of broker-supplied versus home-grown algorithms?

Galper: For hedge funds with over $1 billion in assets our numbers show 34 percent are sending their orders using either proprietary or broker dealer algorithms. That's 22 percent proprietary and 12 percent broker dealer.

Traders: And hedge funds' use of algorithms is higher than that of the large traditional asset managers?

Galper: Definitely.

Traders: How important is the sales trader in a hedge fund's choice of algorithms?

Galper: He's pretty important.

Traders: So, the hedge fund trader still needs help?

Galper: I wouldn't say help.' At least half the time, hedge funds are making decisions about which algorithms to use based on relationships. So, if the sales trader is doing good work with the hedge fund to begin with, they are more likely to get the hedge funds using their algorithm package than someone from another shop who claims to have a better mousetrap.

Traders: So relationships are important.

Galper: Half of all hedge funds say that relationships are the primary reason why they choose an algorithm package.

Traders: Because they trust the guy?

Galper: Right.

Traders: Thanks Josh.