Facilitated by high frequency data and proprietary statistical analytics, speculators can make short-term forecasts based on past prices, volumes and information and decipher the flow of incoming large orders. Once the large liquidity demand is detected, speculators armed with a low latency network can trade ahead of large orders and turn around a quick profit.
Last but not least, HFT exploits any arbitrage opportunity in small price discrepancies between different markets or assets and executes low-latency order placement to realign prices in milliseconds. The high frequency trader arbitrages profits from the correlations among assets and meanwhile strengthens the inter-asset linkages. The market risk at the portfolio level is highly dependent on the correlation.
At the same time, institutional portfolio trades may experience different levels of execution risk in different market regimes. When market volatility is elevated, correlations among assets typically increase, giving single-sided lists fewer diversification opportunities but two-sided lists better natural hedge. So, while there are obvious advantages to HFT, there are also risks.
Buy-side Approaches for Portfolio Managers and Traders
As far as trading performance is concerned, buy-side traders bear the most responsibility for reducing transaction costs and searching for liquidity and as such, they compete intensively with high frequency traders to do it.
The most prevalent approach employed by traders is to execute block orders in dark pools to minimize information leakage. They then run low-latency algorithmic and smart order routing technology to search liquidity in different venues. Their broker-dealers and vendors provide them with the same level of cutting-edge technology used by HFT firms.
The entire trading community is now engaged in a technology arms race to be competitive in these intense markets. Obviously, the traders’ sole responsibility is on the trade list. So, can portfolio managers have any effect on the trading performance? The answer is clearly yes.
Portfolio managers, with their knowledge of investment style and portfolio holdings, are in a better position to evaluate the most appropriate implementation strategy to their portfolio when they look to capture the maximum alpha and align portfolio beta. PMs can comfortably take advantage of the liquidity provided by HFT if the trade order is the right size, the trading pace is the right speed and the list risk is the right position.
When doing portfolio construction, PMs generally have a list of candidate assets to select from to meet their risk-return ratio. If permitted by policy, PMs may reduce the trade size and diversify their investment to alternative names in order to alleviate the liquidity demand and avoid information leakage from concentrated large orders.
For instance, a manager may want to accumulate a large position in a heavy equipment company, believing that the stock will benefit from the government’s economic stimulus plan. Alternatively, if she wanted to spread her order to other names in the industry sector that would also benefit, she might send a list of modest orders, which, after being adjusted for the expected market impact, would still make the investment profitable.
Meanwhile, she could further specify the appropriate order descriptions such as trade horizon and participation rate, with the assistance of transaction cost analysis tools to trade at a favorable trading speed. This would allow her to maintain market balance and avoid paying too much of a premium for liquidity.
In addition, when the trade list is two-sided, like in the event of rebalancing or restructuring, the correlation among assets will form a nice natural hedge for the entire trade list. It is thus desirable to send a balanced long-short trade with respect to market, sector and beta and maintain the neutrality throughout the trading period. The well-balanced trade will reduce the execution risk and facilitate a passive trading style over a longer trading duration to patiently trade at favorable prices. In a high volatility environment, the increased correlation in the two-sided list will position the investment well to weather the choppy markets.
Investment and Trading Strategy Alignment
Traders play a crucial role in the investment lifecycle and to implement an investment idea efficiently, they need to know the rationale behind the complicated investment decisions PMs are making so they can make their own trading decisions. PMs also benefit from increased recognition of the aspects of trading decisions.
Only when the portfolio manager and the trader work closely together to streamline their decision making process and prevent information loss will they be able to be truly competitive with HFT technologies. By building a combined trading and investment strategy, investment professionals can comfortably enjoy the benefit from advanced trading technologies and stand alongside it with their own competitive edge.