Group Co.
Towards Alpha Preservation
Traders Magazine Online News, May 3, 2017
In the early days of telecommunications, the clarity of voice transmission was often eroded by the physical distance between callers, to the extent that long-distance calls were sometimes barely even audible. Advances in the technology that supports the phone system have ironed out those kinks over time, and users can now communicate much more easily across continents with little deterioration in quality. A similar kind of transformation is underway in asset management and order execution.
Many investors currently face a frustrating situation in which their expected paper returns greatly exceed their realized returns, largely because of the costs incurred from slippage of information during the order handling and execution process. Investors should be empowered to recoup those costs, and technology can be used to minimize the loss of returns.
Consider the technology stack associated with a typical client trade today. At the top of the stack is the portfolio management system, into which a portfolio manager or investment analyst enters the details of a transaction. At this point, the portfolio manager has a trade idea, usually driven by a clearly defined alpha generation strategy, and is still calling the shots.
But when the trade idea passes to the buy-side trading desk, it flows into an order management system, and the alpha profile of the manager is largely lost. Then when the trade moves into an execution management system, its key characteristics are rewritten into FIX messages so that they can be clearly understood by the sell side. While the messaging is highly effective, the original decisions that accompanied the trade idea have by this point been completely lost.
Quantifying lost returns that may be caused by the passing of an order from one investment agent or system to another is not an exact science and will naturally vary depending on the size of the order and the nature of the parties involved. But there is no doubt that ‘transmission decay’ imposes a significant cost on the end investor.
Much like the early users of telephones who conceded to an inevitable loss of quality when trying to make contact with faraway relatives, investors may well feel there is no way to avoid this transmission decay. If they want to execute an order using available technology, the order has to pass between multiple agents and systems, and that in turn will have some unavoidable impact on the bottom line.
But there is no need to admit defeat so quickly. While it may not yet be widely practiced, it is possible to apply a technology wrapper around all three systems that will preserve the alpha profile of the order as it passes between agents, and continually assess the trade-off between short-term return and incremental impact.
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