Principal Blind Bidding In Portfolio Trading

Planning to bid for an institution's portfolio? A profitable way to utilize capital? Don't be fooled. Every year, broker dealers enter the business and soon quit when losses mount. Only the strongest survive. Among them is D.E. Shaw Securities, one of Wall Street's top principal portfolio-trading firms.

The New York-based broker-dealer subsidiary of D.E. Shaw & Co., which started trading portfolios as a principal in the early 1990s, now averages four principal trades daily, and this year handled one trade with a value of about $1 billion. (A typical principal portfolio trade is valued at only $50 million.)

D.E. Shaw Securities regularly bids "blindly," using quantitative trading technology. But, explains Mony Rueven, managing director in charge of portfolio trading and the firm's 30-strong U.S. institutional equity group, portfolio trading is not for amateurs.

Q: D. E. Shaw Securities is well known as a quant shop that employs mathematical models in trading. So why is it handling portfolios, or so-called equity baskets?

A: Trading portfolios on behalf of institutional clients fits in very well with our other dealing activities, where we make markets or provide liquidity in equities, convertible bonds, warrants and equity derivatives, both in the U.S. and overseas.

It is also a business in which our quantitative-trading and risk-management expertise gives us a clear competitive advantage. It is no secret that sophisticated institutional investors have analyzed their holdings as portfolios for a long time. Only in the last few years, however, has the buyside begun to see the often substantial benefits of trading lists, or portfolios, rather than individual positions.

D. E. Shaw Securities, for example, often provides institutional clients with analysis to help them decide how they should trade particular lists of stocks as a portfolio versus individual positions, as a principal versus agency positions, and so on.

The institution has a number of choices: principal basket trades, agency basket trades, incentive agency trades, basis trades and EFPs [exchange for physicals]. While they're sometimes used to satisfy special trading needs, institutional investors most commonly use basket trades to invest new cash flows, change asset allocation and rebalance portfolios.

Q:Let's focus on a principal basket trade. Provide an example.

A:Say a money manager is rebalancing his portfolio and has $50 million of equities to buy, and $50 million of equities to sell. He'd basically have two choices about how to execute this list. He could execute it conventionally, doling out individual trades on an agency basis to brokers. The brokers would work them on the floor of an exchange or on an electronic communications network.

Alternatively, the money manager could approach a firm like ours, which, without seeing the trades in the list, would bid for the entire portfolio as principal, offering to execute all of the component trades at market-closing prices for a flat, per-share commission. That's called blind bidding.

Q:How can you bid on a portfolio as principal if you don't know the positions it contains?

A:Here's how it works, mechanically: Every month or so, we provide our clients with a floppy disk containing the latest version of our proprietary portfolio-bidding software.

Whenever they like, they can run this software on a list of positions they'd like to trade. The program will generate an encrypted bid (but no information about actual positions) along with a two-page report giving some of the macro-characteristics of the clients' portfolios things like dollar value long and short, percentage Nasdaq versus listed, index tracking, average spread and some other statistical measures.

The client e-mails or faxes this report to us. We then analyze the report, decrypt the bid and contact the client with the actual price, say 12 cents a share.

All of this means that we're willing to sell to the client all of the positions he wants to buy, and buy from him all of the positions he wants to sell, for a flat 12 cents a share over the entire portfolio. Trades for exchange-listed stocks would occur at their closing prices on the relevant primary exchange, and trades for over-the-counter stocks would take place at the midpoint of Nasdaq's inside market at the close. The bidding process is competitive.

If we're the low bidder and we win the basket, we don't actually see what it contains until after the close, which is when the trade occurs.

Q:Why would a money manager pay 12 cents a share to trade this way, when he could pay an agency commission of 6 cents a share to work these trades conventionally?

A:You have to remember that commission costs are only one component of overall trading costs. There are many trades for which slippage and opportunity costs substantially outweigh the more explicit costs of commissions.

Since all of the position risk in the case of a principal basket trade is transferred from the client to D.E. Shaw Securities, the commissions on principal baskets are usually higher than commissions for agency trades. Because a client's slippage and opportunity costs are effectively zero, however, overall transaction costs are often lower with a principal basket trade than they would be with other methods for trading the same basket of stocks.

Q:Can you help an institution decide the best way to trade a particular basket on a case-by-case basis?

A:Yes. We're asked to do that quite often. The huge focus on transaction costs in recent years means that the buyside is more sensitive than ever before to hidden costs, like slippage and opportunity costs. So, we're able to use our proprietary models to help clients analyze how much slippage they should expect to suffer completing a particular trade under various time horizons. We show them the numbers, and then let them decide how to trade.

Sometimes, the smartest thing for the client to do is to have us trade a basket on an agency basis, whereby we use our quantitative trading techniques to minimize market impact. For other baskets, trading as principal is best. It's all in the numbers.

Q:What are the most common applications for principal basket trading?

A:Principal basket trades are ideal for high-opportunity cost trading, when a portfolio manager believes it's important to move money into new stock picks quickly.

Q:Some bulge-bracket firms also bid for principal baskets. How can

D.E. Shaw Securities compete against larger firms?

A:You have to remember that firms win principal baskets from clients via a competitive bidding process. Since the executions offered by competing firms is the same trades always take place at market-closing prices clients almost always award the basket to the lowest bidder.

So, the question really is, How can D.E. Shaw Securities bid so aggressively for these trades?'

The answer is that we believe our risk-management tools to be superior to anyone else in this business. We can bid aggressively for a portfolio because we think we can hedge it more effectively and less expensively than our competitors. That allows us to liquidate the positions very patiently over time.

In fact, we probably bid more aggressively than anyone for difficult trades small-cap and mid-cap baskets included because we have a much better understanding of exactly how much it will cost us to hedge and liquidate difficult positions. It also helps that D.E. Shaw Securities has substantial capital.

Q:Is the field of competitors on the dealer-side crowded?

A:It's funny. Every year some new firm decides to enter this business. They bid too aggressively, win lots of baskets, lose $30 million dollars and drop out of the business six months later. Our pricing is quantitative, not seat-of-the-pants. We're happy to lose a basket if someone else is bidding too aggressively for it.

Q:Do you think portfolio trading will become more popular?

A:It's becoming more common every day. Once upon a time, it was only quantitative money managers, or those who were especially good at measuring transaction costs, that understood the benefits of trading this way.

Today, we're trading with some of the largest pension funds and mutual funds in the world. But I should point out that it will always be the case that different modes of trading make sense for different trades. The portfolio-trading shoe doesn't always fit.

That's why we offer agency baskets, principal baskets, single-stock agency trades, third-market trades and block executions. The trick is knowing what trading mechanism makes the most sense for a given trade, and then helping your customers optimize the implementation of their investment decisions accordingly. This is a concept we call "smart liquidity."

We believe, in fact, that the market makers and dealers around ten years from now will be the ones who have learned that one size doesn't fit all.