Outlook 2005: Trading

For much of the coming year, U.S. institutional equity traders will be focusing on changes to the market's structure, even as they try to help their portfolio managers squeeze out more alpha by trading quicker, smarter and more efficiently.

"We're going to see some real closure on probably the biggest market structure change to hit the industry since the 1997 order-handling rules," said Ted Oberhaus, director of equity trading at Lord, Abbett & Co. LLC, Jersey City, N.J. "This is going to be a huge change."

That "real closure," however, has taken some time to reach Wall Street.

The Securities and Exchange Commission first proposed its Regulation National Market System last February. The proposal seeks to improve linkages between market venues — exchanges, alternative trading systems and electronic communications networks — to allow investors easier access to the best prices. It also seeks to update sub-penny pricing rules and market access fee guidelines.

After a round of public comment, a revised proposal over the summer and another round of public comment in the fall, commissioners laid out their final proposal Dec. 15 and opened a 30-day public comment period. SEC Chairman William Donaldson said he expected the commission to be "in a position to act on Reg NMS early in the new year."

Even if the SEC enacts Reg NMS in the next few weeks, traders expect full implementation, with new market venue linkages and other structural changes, to take at least another year.

In tandem with the SEC's proposal, the New York Stock Exchange is awaiting SEC approval on its plan to recreate itself as a hybrid market. The new Big Board would give investors more opportunity to trade electronically while reserving a place for the exchange's floor-based manual auction system.

Mr. Oberhaus said the firms best positioned to handle any market structure change — either dictated by the SEC or driven by the NYSE — are those that have embraced technology that gives them the flexibility to search for and find liquidity, wherever it might be, and to handle trades quickly and efficiently.

"It's all about electronic trading," concurred Ananth Madhavan, global head of trading research at Barclays Global Investors, San Francisco.

Mr. Madhavan added, however, that electronic trading systems need to be matched with analytical tools that help traders balance the sometimes mutually exclusive factors of price and speed of execution, and traders who know how to use those analytics.

Joan Stack, trading manager at the $60 billion Ohio Public Employees Retirement System, Columbus, agreed that the big story in trading this year is automation, driven mainly by potential changes at the Big Board.

Ms. Stack said she would be more willing to trade on an automated NYSE; now, she often goes directly to an electronic trading system.

"Anything the NYSE floor can do to make it a little more auto-execution-friendly" is a good move, she said.

John Wheeler, head trader at American Century Investments, Kansas City, Mo., said that for many buy-side institutions, the venue is and will remain a secondary concern.

"We don't care if the NYSE wins, as long as it's a level playing field," he said. "The transfer of stock from seller to buyer should be as smooth and as efficient as possible.

"The best days are ahead of us, as far as market structure goes," he added.

Last year also saw a rush of firms — sell-side brokers and technology vendors, primarily — launching algorithmic trading systems and strategies to provide buyside traders with better ways to handle orders.

Traders said that this year, while more institutions are likely to adopt some of these methods, the excitement over them will die down.

"The hype of algorithms wears off after you realize it becomes part of the workflow," said Ben Sylvester, managing director of equity trading at Babson Capital Management LLC, Boston.

Mr. Oberhaus, an early adopter of algorithmic trading, said that with so many algorithms available, many are starting to look alike.

"The question is how many do you need," he said. "We're looking for real enhancements."

Algorithms handle trades automatically to specifications set by the trader, such as executing a trade at the volume-weighted average price. VWAP is a common, though often maligned, benchmark because it is simply an average price.

"I think the hype over algorithmic trading is going to die down. Buy-side traders are going to find that (algorithms) are useful, but they only fill a niche. They're not the end-all for executions," said David Brooks, head of trading at Boston Co. Asset Management LLC, Boston.

"The second trend I expect is a lesser focus on VWAP as a benchmark," he continued. "With (trading) desks becoming more educated in the process and better informed on how to integrate results into the investment process going forward, the focus will be more on implementation shortfall."

Broadly, implementation shortfall measures the difference in a security's price between the time the portfolio manager decides to buy or sell it and the time the order is executed.

At BGI, traders have been adopting algorithmic trading capabilities and the firm has been building the infrastructure to handle more electronic trading and real-time trade processing, according to Mr. Madhavan.

"We're doing things a lot differently than we were a few years ago," he said. "We like to trade in venues that are automated, that have a certain amount of transparency, that provide electronic execution, speed and liquidity."

Some buy-side traders are taking a more cautious approach to electronic trading.

"There are a lot of stocks out there. Once you get beyond the most liquid names, electronic trading will not add a lot of value," said George Bodine, director of trading at General Motors Asset Management, New York, which manages GM's $86 billion in pension assets. "Worse yet, it may detract from your trading performance if handled through an improper execution strategy."

Mr. Brooks said he expects volatility — which reached historic lows in 2004 — to pick up this year, leading him to take a measured approach to electronic trading.

"The way we prepare for a return to a normal volatility environment is by not swinging too far to automated trading," he said. "We're really in a partnership with brokers, letting them know how important they are to us so when we get back to a more momentum-driven market, and algorithms break down and ATS (alternative trading systems) may not have the liquidity we need, we'll be able to access capital.

The advancement of electronic trading is all about keeping implicit transaction costs such as market impact and opportunity cost as low as possible, traders said. Combined with potential changes to the market structure, which are likely to encourage more block trading, traders expect to have a greater impact on their funds' bottom lines this year.

"The information we see from our transaction cost analysis indicates there definitely is a cost to slicing and dicing your order into very small pieces over extended periods of time," Ms. Stack at OPERS explained. "Larger trades done soon are generally the more cost-efficient trades, and if the NYSE moves along the path of more automation, they will regain institutional traders' confidence to an extent that might lead to an increased willingness to trade blocks."