Hedge Funds Seeking Transparency From Sellside

A majority of U.S.-based hedge funds want greater transparency into their trading algorithms and their exposure to dark liquidity, and they are asking for greater disclosure about how their orders are handled, according to a new report by Tabb Group.

As volume has dried up, nearly everyone on the buyside has looked to review broker lists, cutting back on the number of brokers they use and getting rid of those brokers that don’t measure up. But hedge funds in particular are increasing their expectations of the sellside, demanding greater transparency from brokers.

Better data allows those hedge funds equipped with the right tools to improve their products, compare brokers and fine-tune decision-making processes, the report found.

Of the hedge funds surveyed, 53 percent said they wanted improved operational transparency in their algorithms. A full 72 percent said they are now using their algos to access and aggregate dark liquidity.

Insight into algos and smart order routers provides a better understanding of what hedge funds can expect in terms of where a trade goes, and it can also provide helpful information to placate inquisitive investors, according to Miranda Mizen, a principal and director of equities research at Tabb and author of the report.

“There is a much greater need for transparency across the board,” Mizen said. “That stretches right up into the investor side as well. Investors are getting more knowledgeable. They’re getting more sophisticated. They’re inquisitive. They want to know.”

Mizen said the algo market is highly competitive, and hedge funds want to use algorithmic tools they know will work the way they want them to. Only by understanding how an algo works can a trader predict how it will behave, she added.

Mizen said hedge funds are worried about high-frequency traders, but they have other concerns as well. They don’t want to be overexposed when algos spray their orders out across numerous venues. And they don’t want orders routed to certain venues just because they have the best discounts for brokers. In order to better monitor their algos, funds want more data.

Fortunately for hedge funds, most are already comfortable with receiving large quantities of information and processing it, so unlike some other algo customers, they generally have the capability to interpret and use information they receive from the sellside.

One piece of information they want is how their orders get placed. Hedge funds want to know how their order flow is being exposed to the market and whether it is accessing all of the points that they want without being exposed to unnecessary leakage.

“We’re seeing this a lot more with the buyside asking the sellside, ‘How do you prioritize? How do you price? Where do you go to, and how do you make decisions?’” Mizen said. “At the end of the day, it’s my order.”

The study surveyed 51 U.S.-based hedge funds trading equities, though 84 percent of the funds said they also trade foreign stocks or non-equity products.