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December 08, 1997 12:00 AM

STOCK BROKERAGE GETS A 'QUANT' LOOK

Paul G. Barr
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    NEW YORK -- Executives for D.E. Shaw Securities L.P. want to revolutionize institutional brokerage by applying technology and money management diversification techniques to equity brokerage.

    Having grown to be a leader in principal package trading in a relatively short time, the quantitative brokerage firm founded by former professor David E. Shaw now is grabbing for a bigger piece of the business of brokering single stocks on an agency and third-market basis.

    "Building a quantitative investment bank is what David has wanted to do for a long time," said Mony Rueven, senior vice president for D.E. Shaw Securities, a unit of D.E. Shaw & Co. L.P.

    "We want to expand it horizontally, vertically and all the way around," he said.

    Industry participants familiar with D.E. Shaw say it has a decent shot at becoming a major player in single-stock brokerage, given its history of success in principal trading, and traditional brokers' slowness to change.

    At least one money manager, though, voiced concern about trading with a firm that is also a competitor: D.E. Shaw made its name and most of its money trading in a proprietary hedge fund, where its trading techniques originated.

    "They've set a standard that other (brokers) are trying to work toward," said Mark Edwards, director for trading consultant The Plexus Group, Santa Monica, Calif., speaking of D.E. Shaw's business in principal package, or basket, trading.

    D.E. Shaw was the first brokerage firm Mr. Edwards was aware of to apply standard portfolio construction techniques to managing its equity book, the portfolio of stocks a broker owns as a result of its trading with customers.

    Moreover, he said, established brokerage firms have had a long time to adopt those techniques on their own, but for reasons related to their culture, haven't done so.

    In theory, other brokers could catch up to D.E. Shaw, he said. "But will they?"

    D.E. Shaw's biggest competition is likely to come from an even younger upstart in the business.

    The big brokers are not that interested in operating the way Shaw does, said Nicholas Gianakouros, vice president of D.E. Shaw Securities.

    D.E. Shaw relies heavily on computer technology, substituting hardware for people. That kind of approach would entail a wholesale restructuring of the business for traditional brokers, D.E. Shaw executives say.

    And even if the larger firms did want to use D.E. Shaw's approach, "getting to where we are is not straightforward," Mr. Gianakouros said.

    D.E. Shaw the broker came to be as a result of a hedge fund started in 1988 by Mr. Shaw. The fund seeks to find price discrepancies in stock prices, arbitraging them using computer technology.

    After deciding to find ways to apply its trading skills in other areas in 1992, the firm has branched out into a number of other businesses, including brokerage.

    Earlier this year, D.E. Shaw allied with Bank of America to offer its Shaw's equity-related products to BofA's global client base.

    The same technology used in D.E. Shaw's hedge fund is what drives its brokerage business, which has grown quickly.

    D.E. Shaw is considered the market leader in small-company principal package trading, a trade in which a broker agrees to trade a basket of securities knowing only the macro characteristics of the portfolio.

    "They have saved my clients money," about $2.5 million over the past five years, said Theodore Aronson, partner with quantitative money manager Aronson + Partners, Philadelphia.

    He said his firm does more principal basket trading with D.E. Shaw than with any other firm.

    In principal package trading, brokers submit bids on the trade, with the low bid getting the deal.

    Mr. Aronson said the key to D.E. Shaw's success has been its ability to trade out of positions at a better price.

    Mr. Aronson said he tracks the market for stocks he has sold to D.E. Shaw, and he cannot find much of a market effect as D.E. Shaw trades out of its positions.

    "I can watch them. You can hardly tell they're trading in it," he said.

    D.E. Shaw executives won't disclose their trading methods, but say they keep their positions hedged, and use any securities market available to them for the hedging, including derivatives. Mr. Rueven also said the firm is willing to hold a stock for a long time, if necessary.

    Mr. Aronson said his firm has started using D.E. Shaw for single-stock agency trading, an area in which D.E. Shaw wants to expand its business. (D.E. Shaw also is focusing on third-market trading, which involves trading of exchange-traded stocks away from the exchanges.)

    In an agency trade, a broker doesn't buy or sell the security for its own account, but tries to find another willing buyer or seller.

    Mr. Aronson said it's too early to say how good a job D.E. Shaw traders are doing on the agency side.

    Despite D.E. Shaw's success in increasing its principal trading business, a few factors could limit its ability to increase its agency trading business.

    Mr. Edwards of Plexus said that selling D.E. Shaw's style to the more established trading camp will be tougher than was selling its principal package trading.

    "The people that use Shaw (now) think about trading in a different way than a traditionalist.

    "What do I have to do to market to this type of trader?" Mr. Edwards asked. "That's probably the biggest barrier" to D.E. Shaw's growth in agency trading, he said.

    And the firm is small and not well-known. Indeed, more than a few money managers and pension funds that trade internally said they had either barely heard of the firm or didn't know of it at all, when contacted by Pensions & Investments.

    Moreover, John Wightkin, head of trading in the quantitative group of Weiss Peck & Greer L.L.C., Chicago, is hesitant to use D.E. Shaw for agency trades. He said he wouldn't want to disclose Weiss Peck's quantitative trading to a firm that, without a Chinese wall, could use the information in its proprietary trading operation.

    "Are they going to use that information to their benefit?" Mr. Wightkin said.

    But D.E. Shaw's Mr. Gianakouros said: "It goes without saying we have no interest in reverse engineering" other quantitative managers' investment process.

    He said it hasn't been a problem that has come up with other quantitative managers.

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