Converging trading and portfolio strategies in volatile markets can save alpha

NEW YORK — Institutional investors should ride out the storm of volatile markets to obtain best execution, according to experts at a Pensions & Investments round table. That way, they won't give up valuable alpha to tumultuous market conditions.

“We've actually consulted clients and suggested — and encouraged them strongly, let's say — to step out of doing a particular investment or a transition into a type of asset class ... and wait until the volatility does calm down. And we've been successful in doing so,” Timothy Misik, New York-based head of institutional equity trading at Northern Trust Global Investments, told participants at the round table, held in New York on Feb. 6.

Tal Cohen, senior vice president at Instinet LLC, New York, concurred that “in times like these, yes, you do see a lot of customers pull back, take control and empower themselves, because, generally speaking, the unknown — or anything that's ambiguous — tends to introduce friction cost and is a problematic situation not only for the broker, but the client.”

Also participating in the round table were Ian Domowitz, managing director analytical products, ITG Inc., New York; Brian Hyndman, senior vice president transaction services, Nasdaq Stock Market Inc., New York; Scot Warren, managing director equity products, CME Group Inc., Chicago; and Kyle Zasky, managing director EdgeTrade LLC, Knight Capital Group Inc., Jersey City, N.J.

The six panelists agreed that asset managers should view portfolio strategy and trading strategy as complements in maximizing returns. Asset managers should weigh the impact of difficult market conditions — such as those seen during the hectic week of Jan. 21 when troubled French bank Societe Generale was liquidating $75 billion worth of equity indexes — if they want to achieve best execution for their orders, thus improving portfolio performance.

Mr. Domowitz said volatile market conditions highlight the difficulty in achieving best execution for institutional orders.

But best execution goes beyond volatile markets. “Best execution is in some sense a process, not a price,” said Mr. Domowitz. “What I've observed, though, is that there's a temptation to extend the notion of that process well beyond best execution in the sense of the trade. In other words, we now talk, and some ways very successfully, about how these costs can be taken into account at the portfolio level, but we risk a bit of confusion, dilution of the concept.”

As the head of analytical services at ITG, a global electronic agency brokerage and transaction research firm, Mr. Domowitz has much experience analyzing execution data.

“(It's) a process starting at the stock-picking level all the way through to clearance and settlement,” Mr. Domowitz said. “So, I think, definitionally, we're more or less on the same page, but the page seems to get bigger all the time.”

What's more, various types of trading venues — from closed pools of liquidity such as “dark books” to traditional exchanges — have different models that may be better suited for different market conditions. While dark pools might reduce information leakage in a low volatility environment, they may turn into traps if orders sit there and are vulnerable to market swings. Open books, on the other end, allow traders to quickly jump on price movements.

“I think in extremely volatile markets, if you're trading in the public markets, you get the transparency. You know what price you're going to get. You know that you can get a trade done rather than having, you know, a limit order sit in a dark pool, not knowing if that's ever going to get executed, if the market's going to run away from you,” said Nasdaq's Mr. Hyndman.

“I think public markets and dark pools both bring great benefits to the end trader. Clearly, I think there's the ability for both of them to coexist. ... I don't think that you can just trade on one and not the other,” he added. “The dark pools clearly limit the market impact on trading. But in volatile markets, the stats that we see are that the public exchange volumes skyrocket and the dark pools and the internalization engines out there stay somewhat static in their absolute volume.”

The variety of market models and their specific regulations make it more of a challenge to achieve best execution and require an expertise that goes beyond what might be required of a portfolio manager, but portfolio managers turn their trades over to buy-side traders, even in hedge funds.

(For a related story about markets that brokers are forming to battle exchanges, click here. To see a full, edited version of the round table transcript and listen to an audiocast of a portion of the discussion, click here.

“It's incumbent on the broker to become an expert on market structure, rules and regulations, and essentially what trading strategies work in these various markets,” said Instinet's Mr. Cohen.

“Generally, you want to make sure that your customer knows it's incumbent on you to have that expertise,” Mr. Cohen said.

Achieving best execution with a portfolio is even more daunting when dealing with top stock picks in the small-cap sector, which often lacks liquidity regardless of market conditions.

“It's not just during volatile markets, because even during calm markets, there are a lot of securities that don't trade very frequently, that are difficult to get done. In those circumstances, it doesn't make a difference how good your dark book is. ... It doesn't make a difference, you know, what kind of connectivity you have algorithmically,” said EdgeTrade's Mr. Zasky.

The challenge is even greater for global portfolio trading or when facing a transition of a global portfolio. CME Group has a series of equity index futures contracts that allow institutional investors to hedge their positions or gain exposure with a low tracking error.

“Go to where displayed liquidity is, where you've got certainty of execution, because I think — back to many of the things that we talked about before — there's a trade-off between certainty and impact. If I can see a displayed price and I'm certain of execution, I need to at least participate in that market. Because I can wait and hope things get better ... or I can work and take advantage of liquidity that's out there presently,” said Mr. Warren of CME Group.

Best execution is even more of a challenge these days when brokers, the intermediaries and exchanges compete for institutional order flow, sometimes stepping on each other's turf.

“A line of demarcation is (that) the exchange doesn't commit capital to the trade. So, essentially, we're neutral, we're Switzerland in the equation, and that in a large part, gives institutions confidence that the playing field's more level,” Mr. Warren added.

“I've got a healthy tension now between the institution and the broker. (Brokers are) working as an agent, they're also working as principal. How do I get that divide, and am I comfortable with the Chinese walls and information barriers within the broker?” Mr. Warren said, referring to the concern that institutions sometimes have about their brokers taking positions for their own account, based on their clients' orders.