Buyside traders’ relationships with their firms’ portfolio managers are clearly evolving as PMs fret more about performance amid a rapidly changing and fragmenting marketplace.
While not all traders and PMs work closely together, enough have decided that closer collaboration will result in better trades. This is particularly true when the markets hit a patch of extreme turbulence-as they did in January.
Confusion, frustration and incriminations can surface between the desks during these times, as each side watches price and market impact estimates quickly become irrelevant and chunks of orders go unexecuted by the day’s end. In an environment where the Chicago Board Options Exchange’s Volatility Index (VIX) hovers around 30 and quick decisions mean everything, both sides say it’s helpful if PMs know what they can expect from the markets and traders know what’s crucial for their PMs’ portfolios.
“In times of volatility, you realize how much communication [between the two desks] matters,” says John Despotopulos, head trader at Boston-based Lee Munder Capital Group. “Because in volatile times a stock moves so quickly, we need to make our decisions faster. The better updated we are on what the feel of the PM is, what their thought process is and how aggressive they want to be, the better we are.”
The relationship matters because the two must work together to ensure that PMs manage their portfolios’ components to get the best rate of return on their clients’ investments. The trader’s ability to buy or sell those components at certain prices or times has a direct impact on this.
If, for example, a PM wants to buy a stock trading at $25 for his fund that he thinks will jump to $35 in a year, and the trader pays $27 for it, the PM’s projection will have lost 20 percent.
But the extent to which PMs and traders interact over a specific buy or sell varies. Traders generally work under PMs, but are given autonomy in how they trade. For some traders, PM oversight is minimal. PMs focus on picking stocks while trusting the traders to do the right thing.
This is the situation that works for Cheryl Cargie and Jason Tyler, both at Chicago-based Ariel Capital Management. Cargie, head trader, and Tyler, senior vice president on Ariel’s investment committee, describe their relationship as a partnership. Cargie says Tyler needs to feel confident she’s getting her trades done, but doesn’t need to know exactly how she’s doing it.
“They don’t understand all the technologies we have, and I don’t know the technologies they have,” Cargie says. “From a trader’s point of view, the more understanding of trading technology a PM has the more micromanagement comes into play. And that’s the last thing any trader wants.”
From Peripheral to Integral
Communication is one important factor in the relationship. But how well firms manage clients’ investments can also boil down to a PM-trader relationship predicated increasingly on how much each knows about the other’s goals at all times.
Over the decades, traders learned more about market microstructure and portfolio strategy. In return, as the exchange floor has gone electronic, they’ve started to educate PMs about trading technology and venues. Make no mistake: PMs still do the stock picking while traders do the trading. But increasingly, each knows more about how the other does his job, to help him do it better.
“In the old days, a trader may have just taken the order, given it out and moved on to the next trade,” says Joe Burrello, global trading director at IronBridge Capital Management. “The buyside trader has to become smarter in understanding the investment process.”
Four years ago, this magazine wrote about how buyside traders had redefined their relationships with PMs over the past two decades as they emerged from the operations side of the business. Decimalization had forced them to gain more trading and market expertise to execute block trades. Many started earning MBAs and CFA designations to get it.
Today, the relationship has evolved to the point where buyside traders have, with the help of technology, become a more integral part of the investment process alongside PMs. They’ve transitioned from merely settling securities 20 years ago to entering orders electronically around five years ago to sometimes helping PMs fill out sectors in their portfolios today.
Portfolio 101 for Traders
IronBridge Capital has about $4 billion tied up in small-cap, small-and mid-cap, and large-cap global products. Burrello, a 20-year-veteran trader there, sits about 10 feet away from the firm’s PMs and talks to them constantly. He knows the direction of their valuation models and uses that to help them. His strategy is to join trading-and what he sees in the market-to what the PMs are trying to do.
“On the trading side,” Burrello says, “it allows us to run through our stocks and say, I know you’re trying to add to a specific sector, and this one of our stocks is getting to a level where it looks good to buy.’ Or, the stock’s been under pressure and the pressure’s off because a big trade goes up.
“If I didn’t know what sector they were looking at to increase, I may just think it’s another big trade and not say anything. So we’re looking at that kind of teamwork-on what they’re looking at and what their thoughts are on the portfolio-and then that lets the trading desk connect some dots to provide them great feedback, as opposed to just noise.”
Asset managers are also helping traders. According to Lee Munder’s Despotopulos, PMs give him their rationale for buying or selling their stocks, which can determine how he trades. For example, without this input, Despotopulos says he might use a passive approach to start an order and place it in a dark pool when he likely would have been better served using an aggressive approach.
Trading 101 for PMs
But Lee Munder PMs know this because traders have been educating them on the trading process and sourcing liquidity in a fragmented marketplace. The firm’s funds include small-cap growth and value stocks. As the stocks tend to be less liquid, their execution requires a lot of interaction between the two departments.
In the past, for example, a PM may have sent the trader a $150,000 order in three separate $50,000 tranches. That strategy risked other traders jumping in between each tranche and taking the available liquidity, Despotopulos says. Today, the PMs are more apt to give Despotopulos the entire order up front because they’ve learned how dark pools work, and how in different scenarios he can use them for better executions. And Lee Munder’s PMs like to know where the liquidity comes from.
“There’s no question things are much more fragmented now,” he says. “If you’re talking the New York Stock Exchange, we might have some of the order there. We might have some in a dark pool or a crossing network to protect ourselves. It all goes back to educating the PM on why we’re doing certain things-you need to be protected. You need to be in certain spots, because you just don’t know where that volume is going to go.”
The PMs’ and traders’ desks at Jacksonville, Fla.-based Sawgrass Asset Management have established a “feedback loop” that keeps information on orders flowing constantly. The long-only firm deals in large-cap and small-cap growth stocks, and typically makes changes across entire portfolios-as opposed to individual stocks. It relies on the constant flow of information to do this efficiently. Also, about 99 percent of the firm’s orders are market orders, and most are time-sensitive, rather than price-sensitive, so the traders have a lot of discretion over them. As such, it’s helpful that its two traders sit steps away from its three PMs, says Dean McQuiddy, Sawgrass’ small-cap PM.
McQuiddy has worked with equity trader Janet Emmick for almost 20 years. In the past three or four years, he’s learned from her and others how to use the firm’s pre-trade cost analysis findings to inform his orders, as well as his expectations. The tool analyzes his stocks-or those he’s considering for purchase-and gives him a matrix of how hard he can push on a particular name. It affects how much of each name he’d buy at a particular time.
“We have tools that say: If you’re trying to buy 30,000 shares in something, you should be able to do that, and this should cost you X basis points,'” McQuiddy says. “Obviously a lot of that gets thrown out the window when you have the type of volatility that we’ve had. But we don’t ask our traders to do the impossible, which is where the friction between the two sides often comes in.”
McQuiddy says he trusts his traders’ experience and that they’re using all the available avenues of liquidity and are up to speed with the latest, most powerful trading technology. For her part, Emmick says it’s important for her to know that McQuiddy’s door is always open, particularly when the seas get choppy.
“If we needed guidance, if we felt uncomfortable with the way a particular trade was going,” she says, “we would want to know that we could go in and have a conversation with the PM, and for the PM at that time to give us some color on that particular name, and maybe why they’re doing what it is they’re doing.”
Of course, at the end of the day, it’s still about trading and portfolio management. After the dark pools, algorithms and pre-trade cost analysis conversations have finished, McQuiddy looks at his stocks and asks Emmick: “How much did you get done, and at what price?”
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