This article first appeared in the European Financial Review, http://www.europeanfinancialreview.com/?p=17446
By Irene Aldridge
With all the changes happening to the markets the past several years, author Irene Aldridge discusses how technology has significantly shaped the execution quality for portfolio managers. The article emphasises the realities of a data-driven industry wherein better information means better success.
Investment managers are increasingly concerned about the quality of their execution. Indeed, how you execute the orders in today’s markets may make or break investment profitability. Changes to the markets over the past several years place execution quality at the top the priority list for investment managers.
Most of the changes in the markets are directly related to computing power and automation within the financial services sector. Automation is a driving force in the financial markets: today’s computers are scoring mortgage applications, reviewing technicalities in swap legal agreements, process trading orders and even increasingly make investment decisions in a push toward a lower-cost automated portfolio management. Automation drastically reduces costs, improves the customer experience, and lowers the expenses of businesses across the industry ensuring competitive survival. Relative to other areas of business, execution expense now really matters in ways not seen before, and nickels and dimes associated with execution decisions may or break a portfolio manager.
What are the current market forces that portfolio managers should be aware of in the execution space? The most obvious issue facing most portfolio managers today is the trading venue selection. For the US equities alone, along with the 21 exchanges, we now have 36 alternative trading systems (ATS), also known as alternative trading venues or, simply, dark pools. Dark pools trade anonymously and without displaying order information before trades are executed. The lack of displayed information is the key difference between dark pools and registered “lit” exchanges. Exchanges show the entire limit order book, down to how many shares are in each limit order, while dark pools hide all limit-order book information. Institutional investors that trade large blocks and lack appropriate algorithmic expertise may go to dark pools and “hide” their large orders from other traders. Then, however, they risk the traps of unregulated markets and other, potentially malicious market participants also hiding in the dark. Future traders, too, are presenting with competing platforms: ICE and CME are just two large powerful names in the global trading of futures contracts with many upstarts taking care of matching various kind of derivatives around the globe. Finally, in the 5×24 forex markets that truly barely sleep, rules are few and execution choices are close to limitless.
High-frequency trading (HFT) is another execution concern for portfolio managers. HFT likewise capitalises on plunging costs of technology. When programmed correctly, HFT software has built-in advantages over manual trading. Computers seldom become ill, are hardly emotional, and make, in short, superior cool-headed traders who stick to the script and don’t panic.
Of course, some recent research purports that some people, especially those attuned to their intuitive or biological responses, can outperform machines. Well, good for those few! By and large, however, human traders tend to be a superstitious, irrational lot prone to, well, human behaviour, and no match for their steely automated trading brethren.
Perhaps one of the largest advantages of machines, however, is not that they can contain their nonexistent feelings, but in their information processing power. Humans have a finite ability to process data. We may, possibly, be able to stare at some 16 screens all at once, but our eyes can still only process 24 distinct visual frames per second. Should the information update faster than that, we simply miss it. Computers, on the other hand, can process unlimited volumes of data at the speed of light.