A CIO I know at a global investment house once told me that he referred to his trading team as the “alpha destruction desk”. It sounds a little unfair, but it wasn’t meant to be, and he was not being unduly critical of his traders. It merely reflected his perception that no matter what the investment models predicted in terms of theoretical upside, the real outcome of the asset, sector or individual stock re-allocations his portfolio managers came up with was wholly dependent upon the ability of the trading desk to implement them with the least cost impact.
Not too long ago many buy-side trading desks could function quite adequately with just a few screens on their desktop, one for OMS/EMS functionality, another for IOI’s and perhaps another for market data and messaging. Today the average trader’s appetite for technology on the desktop has changed to the point where there are so many screens there is no longer space to keep a photo of the dog, and justifiably so; trading is after all more competitive and more complex. In fact, when I next meet the CIO I refer to above I might suggest he brands his trading desk as Aethon, the legendary King of ancient Thessaly on whom the gods implanted an insatiable hunger.
Buy-side trading desks really came of age in the 1990’s when the first wave of traders migrated from sell-side to buy-side often as poacher turned gamekeeper. Over the years more business has been executed electronically and the skillset required on the buy-side has diversified. For some funds, maintaining sound relationships with sell-side firms willing to share their knowledge of market flows and show natural blocks or use their capital to fill orders has proved crucial, whereas for others getting to grips with electronic trading tools such as DMA and algorithms became more important. No single solution works for all and whilst some perform a multi asset function, others become heads of “scientific trading”. In almost all scenarios the bar has been raised and the latest generation of increasingly numerate and tech savvy traders are even more demanding in their needs for responsive trading and analytical technology.
Giving your front office the tools they need
A good buy-side trading desk requires continued investment, driven not only by the desire to compete successfully in the technology intensive world of the trader, but in order to remain compliant with the ever-increasing regulatory burden. Unfortunately, regulation and competition are rarely aligned, and a dollar invested in regulation will rarely realize a benefit in performance. Whilst the margins of fund management firms remain healthy at around 34% in the UK and 39% in the US, everyone expects they will come under pressure as consumers become more price sensitive, costs increase, and performance is squeezed.
It would however be short-sighted to look at investing in trading resources as a begrudging reaction to over burdensome regulation. The reality for investment managers of all persuasions is that if they wish to stay in the game, their trading desks have to remain competitive, and in order to do so they should be prepared to address a number of major challenges.
The trading of many of the new asset classes embraced by MiFID 2 such as OTC derivatives and bonds will very likely change as the new regulations will undoubtedly have an impact on market structure. Such changes are hard to predict, but given the experience of the equity market post- MiFID 1, one might expect a far more complex structure to emerge and continuously evolve, with both real and illusory liquidity of variable “toxicity” spread across a range of exchanges, OTF’s and
SI’s. It is worth noting that those equity traders able to navigate the complex array of equity trading venues in order to find dark liquidity are averaging over 13bp of improvement whenever they find it.
Not only might liquidity become fragmented, but in the most liquid non-equity instruments the introduction of low cost and efficient multilateral trading platforms may well lead to the shrinking of tick sizes, narrowing of spreads, faster trading, and fragmented order sizes. A fund manager may have an alpha horizon of decades, but once anything akin to HFT starts playing in the same sandpit then you need to up your skillset and technical capabilities and start dealing with the exponential increase in orders, fills and data points that these market mechanisms generate.
Winning the technological arms race
Active and passive fund managers do not just compete with each other, they compete against their peers. It goes without saying that in both cases poor trading can undermine the competitive position of a fund. Active fund managers are having to find scarcer alpha opportunities, and when they are identified they need to be acted upon quickly. It also follows that that the more skilled and efficient the trading desk, the more alpha opportunities can actually be pursued. Passive fund managers are possibly more exposed to price-based competition as they face off to customers who can be acutely sensitive to both costs and performance. ETF’s may be flying off the shelves so to speak, but that does not mean they are all optimally constituted or competitively priced. Traders more so than portfolio managers are best positioned to assess the quality of ETF pricing, having a better understanding of the liquidity characteristics of the underlying components.
The most successful trading desks are those that have become closely integrated with their colleagues in portfolio management. If the trading desk understands the objectives of the fund they can help by identifying liquidity that provides opportunities for capturing alpha that the typical portfolio manager would never have known existed. Traders can also be far more adept at identifying alternatives to achieving the fund objectives; the desired exposure may be achieved far more quickly and effectively by using derivatives rather than wading into the underlying instrument.
Fundamentally trading is somewhat of a technological arms race. The technology services and data being used are increasingly provided by trusted independent suppliers as traders are moving away from being dependent on broker provided services that may be inherently conflicted.
The data that is essential in order to demonstrate best execution, broker selection and trader performance, can also be part of an iterative feedback loop that can be used to benefit portfolio construction. Some take the view that for active managers to improve portfolio performance they should look to place riskier bets, and have fewer but higher conviction holdings. The ability to adopt such an approach can be helped by having a trading desk that has an accurate understanding about what the price impact will be, rather than a gut feeling about how well they might perform. Pre-trade analysis has already delivered proven benefits in some firms by filtering out investment ideas that would have lost money once the full cost of raising and investing had materialized, and it is often the portfolio managers who find it most difficult to adjust their behavior and the urge to over trade.
Despite these examples of how an adequately resourced trading desk can boost fund performance, regulation looks set to continue to raise the fixed costs associated with having an internal trading desk. Industry surveys indicate that firms expect their compliance costs to double by 2020, with the average large European fund management firm expecting to spend more than EUR 10m complying with MiFID 2. Whilst some like Schroders have declared that they expect it to have a one-off impact on their cost-to-income ratio, I suspect many underestimate the ongoing cost impact of continued compliance. Firms may be underestimating the resources needed to
implement and manage the governance and control processes surrounding such things as best execution, broker evaluation, venue analysis and market abuse.
From January 2018 the execution of a single trade will trigger the need to implement significant audit, monitoring and governance controls. The trading desk will need to remain compliant with new and demanding changes to regulations relating to trade and transaction reporting, record keeping, and execution quality management. Firms will have to do additional and more complex analysis of broker performance and trading venues, possibly treating the former with the same rigor as they would any other outsourcing arrangement.
When trade and transaction reporting is cited as the most challenging aspect of MiFID 2 most commentators are thinking of the IT challenge of pulling together all the data required from currently disparate middle and back office systems, yet the determinant of who is obliged to report will be where and how the instrument was traded. Accuracy is essential as in the future there will be no ability to play safe by over-reporting. In some asset classes, users will be dependent on ESMA maintaining lists which determine whether stocks have to be traded on an OTF and centrally cleared, a proposal that appears to be built on an optimistic outlook of how smoothly processes will work, not the least of which is agreeing how to unambiguously identify the securities themselves.
Looking forward, managers will need to keep a firm control on costs to control pressures on margins, but care should be taken to ensure mandatory expenditure on meeting regulatory requirements does not detract from essential spending on desktop technology that can improve competitiveness. Alpha that is not “destroyed” as our CIO would have it, is after all alpha, and every basis point helps.