As the high-frequency trading debate rages on, the question isnt if the markets are rigged or not. Instead, investors should ask, “why do institutional investors allow their clients, who are the key losers here, to have their money handed over to HFTs every minute of every day?” Institutions are letting this happen because they havent cared enough about trading, havent seen trading as a valuable contributor to the investment process and have not responded to the dramatic change in the competitive and structural environments in the last several years.
HFT firms have done all of this as theyve invested the money and theyve reaped the benefits. Now that tools are available for asset managers to keep pace, institutions can and should be using them.
The technological and regulatory changes that have driven down trading costs for all buyside firms will not be reversed. However, any change creates winners and losers and many mutual funds and professional investors make it far too easy for HFT firms to profit at the expense of their clients.
The reason is simple; They are in too much of a hurry to trade. Portfolio managers make considered investment decisions, taking time to meet a company, investigate its competitors, read its accounts and model its cash flows. An investment committee may even approve decisions. Then the order is rushed to the dealing desk for immediate execution.
A parallel may be drawn with buying travel tickets online. If you log-on and buy but pay no attention to the cost, you will be scalped. While you may still enjoy your holiday, you’ll also know that the guy one sun lounger over paid half as much for his flights. Professional investors have a fiduciary duty to take better care of client funds.
PATIENCE IS A VIRTUE
In the investment industry, the price of impatience is underperformance. The portfolio manager that takes trading seriously, utilizing the knowledge on the dealing desk and using dynamic trading analysis, will emerge a winner.
The loser stands over the dealing desk demanding that trades be filled. These trades leave a giant footprint in the market, which HFTs do not need millions of dollars of technology to spot. When an asset manager sends a parent order through an algorithm or an SOR for a significant amount of stock, the firm shouldnt be surprised when the market runs from it. Its like showing up to a cattle market with a fleet of eighteen-wheelers mooing and smelling of cow. Dont be shocked and indignant when the price of beef dips a bit. Firms need in-trade market dynamics to adjust strategies in real time.
Money managers also fail by employing inappropriate benchmarks. When they should be concerned with maximizing a funds performance, they instead monitor the variance of slippage on each order. There is little to be gained by meeting an average when the whole market has been temporarily distorted by your trading. These firms should reward traders for minimizing the total costs of dealing instead of instructing them to trade everything too quickly.
Portfolio managers may say that they make investments over the long term to gain large returns and a few basis points on a winning trade will make no difference. Yet, there are good stock pickers at many firms, at least as many as there are outstanding stocks to own, and a few basis points on every trade will make a difference. Furthermore, the manager must contend with inflows and redemptions, placings and IPOs, option overwrites and even trades driven by the risk controller. These must be managed in the optimal way.
Fund managers have invested in trading technology. Firms have automated processes, trade electronically and route to the smartest algorithms available in the market. Still, technology advances at a rapid rate and it is not enough to conduct pre and post trade analysis to guess what might happen in the market on any given day.
Real time, intraday analytics are available to monitor market microstructure, allowing traders to track the activity of competitors, to see what the HFTs see and to trade accordingly. It is no longer sufficient to spend the IT budget connecting portfolio management software to the algorithms of a firms favorite investment bank. Firms need technology that watches orders in real-time and alerts when return, spread, liquidity or volume moves out of the normal range because humans are unable to do that.
Ninety-five percent of stocks on any given day are trading in a normal range of spread, liquidity and volume. Its just algos trading against algos. Firms dont need to spend time on orders in those stocks; they are wise to select the algo they think is most appropriate, then select the one thats about half as aggressive as that one and leave it be until something moves out of the normal range. Good traders are systematic, methodical, and carefully choose their execution strategy and participation rates.
Traders do have the power to monitor brokers, to leave them to do their job when market conditions are normal and to act quickly when there is a significant dislocation. Markets may be monitored through an alerts panel calling traders attention to where it is needed and that otherwise sits in the background watching the market.
Pretending there are a bunch of smart nerds out there front running everyone is fun. They are not front running everyone. They are watching firms trade and reacting because firms are enabling them, practically begging them.
The message is simple: firms cannot be passive, They must invest to control their footprints in the market and stop writing checks to the HFT firms with clients money.
Tom Doris is CEO of OTAS Technologies.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
