Alpha is the ability to generate superior risk-adjusted returns compared to the return of an appropriate index. The purpose of most equity trades for managed portfolios is to hopefully create alpha for that portfolio. The hidden costs of not obtaining the best execution can destroy that alpha.
How does the trader know his trade is being treated fairly with respect to other trades being placed at the same time? Is the trade being shown to the right people? The SEC website lists 20 exchanges approved for securities trading. What drives the decision by a trader to use one exchange over another?
CFA Society Chicago’s Education Advisory Group hosted a panel discussion on insights on market structure in the equity market and how this structure affects equity trading today. The moderator was Michael Thompson, CFA. The panelists were Haim Bodek, Nanette Buziak and Larry Harris, CFA. Their backgrounds are as follows:
Michael Thompson, CFA – Mr. Thompson is a Partner and Head of Domestic Equity and Derivatives Trading for William Blair Investment Management. Mr. Thompson began his career in the late 1980s as a securities trader associate with Principal Financial.
Haim Bodek – Mr. Bodek is a Managing Principal of Decimus Capital Markets, LLC a tactical co nsulting and strategic advisory firm focused on high frequency trading (“HFT”) and U.S. equities market structure. Mr. Bodek is the author of two books on market structure and is known as a whistleblower that brought attention to the questionable practices of HFT.
Nanette Buziak – Ms. Buziak is Head of Equity Trading at Voya Investment Management. Ms. Buziak manages a team of equity traders and is responsible for all facets of equity trading and related operations at Voya.
Larry Harris, Ph.D., CFA – Dr. Harris holds the Fred V. Keenan Chair in Finance at the USC Marshall School of Business. Dr. Harris addresses regulatory and practitioner issues in trading and investment management in his research and consulting.
Mr. Thompson began the panel discussion by briefly speaking about his background and introducing each panelist. Mr. Thompson provided a brief history of the changes in equity trading since the late 1980s. When Mr. Thompson began his career, there were only two exchanges and orders were brought to brokers who announced the bid or offer on the floor of the exchange. There were only two recognized equity markets, the NASDAQ and the New York Stock Exchange. By his estimate there are now 13 well known exchanges and 40 dark pools that can trade, with all trades done electronically. Each panelist made a brief presentation which is summarized below:
Dr. Larry Harris
- The need for speed critical, you need to be the first in line for execution or the first to cancel if you don’t want to get hit.
- A buyer grants a “put” option to the market and the market will move away from a buyer over time.
- Brokers can hide orders or search for hidden orders. Dark pools will not show orders.
- Limit trades often come with price discretion. Someone with a limit order of 23 might accept a price of 21; however this fact is not shared with everyone.
- “Maker-taker” fee structures have become more common. The broker will typically extract a fee from the taker and rebate part of that fee in the form a liquidity rebate to the maker.
- There are basically two worlds in equity trading, HFT and non-HFT. Firms that specialize in HFT exploit the structure of the market to take advantage.
- HFT is not really a quant strategy.
- The two biggest HFT firms paid substantial fines to the SEC in 2012 due to the work of Mr. Bodek in exposing the unfair advantage of firms using HFT when competing with traders not using HFT.
- HFT comprises around 40% of equity volume and is still legal to use as long as those firms use proper disclosure.
- Her team is composed of traders, analysts and portfolio managers who are all cognizant of trading costs. The team strives to limit the implicit costs of trading.
- The average print size of an equity trade is around 217 shares; her typical trades at Voya are in the millions of shares.
- Need to assess what venue is appropriate for what trade. Does the name trade in dark pools?
- HFT is not an issue as long as she feels her positions are not compromised. Some venues can be more toxic than others.
- Liquidity appears to be coming out of the market at this time since the dwindling amount of IPO’s are not able to replace firms lost to M&A.
There was a brief Q&A session following the panel’s presentations that touched on the following topics:
- There was some frustration expressed on how slowly the SEC responds to complaints. Since the SEC must follow due process, it is up to institutions to do their own due diligences on these venues and brokers.
- Firms that do large equity buybacks in many cases use minority brokers.
- In assessing what algorithm to use when trading it’s important not to use those that are repeatable and can be used against you.
- Voya’s portfolio managers know what names are not liquid and they will not build a large position in a thinly traded stock.
In response to where they see the market in 5 years, most participants felt there would be little change in that time. With the new administration, Dodd-Frank might be in jeopardy