High-Frequency Trading Round-up

Reuters has three interesting articles on high-frequency trading:

High-frequency trading surges across the globe

Geeks trump alpha males as algos dominate Wall St

Who’s afraid of high-frequency trading?

Interview with Paul Tudor Jones II

Via Absolute Return+Alpha:

What’s so special about macro hedge fund managers?
I love trading macro. If trading is like chess, then macro is like three-dimensional chess. It is just hard to find a great macro trader. When trading macro, you never have a complete information set or information edge the way analysts can have when trading individual securities. It’s a hell of a lot easier to get an information edge on one stock than it is on the S&P 500. When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form. The inability to read a tape and spot trends is also why so many in the relative-value space who rely solely on fundamentals have been annihilated in the past decade. Markets have consistently experienced “100-year events” every five years. While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.

Is it possible to teach someone to be a tape reader — what some might call a trend follower or technical analyst?
Certain people have a greater proclivity for it because they don’t have the need to feel intellectually superior to the crowd. It’s a personality thing. But a lot of it is environmental. Many of the successful macro guys today, they’re all kind of in my age range. They came from that period of crazy volatility of the late ’70s and early ’80s, when the amount of fundamental information available on assets was so limited and the volatility so extreme that one had to be a technician. It’s very hard to find a pure fundamentalist who’s also a very successful macro trader because it is so hard to have a hit rate north of 50 percent. The exceptions are in trading the very front end of interest rate curves or in specializing in just a few commodities or assets.

What’s your take on the next generation of managers?
I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over. When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you? These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the Internet, creates the illusion that there is an explanation for everything and that the primary task is simply to find that explanation. As a result, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust the price action. The pain of gain is just too overwhelming for all of us to bear!

Read the full interview here

Staying Calm in a World of Dark Pools, Dark Doings

Via Jason Zweig in WSJ:

Last week, the Securities and Exchange Commission accused the Galleon Group of hedge funds of trading on inside information. Tens of millions of shares move each day through “dark pools,” where quotes aren’t displayed until after the trade is done. “Flash orders,” appearing for a split second, give some customers a sneak peak at potential trades. More than two-thirds of stock-market volume comes from high-frequency traders, who can buy or sell in less than 400 microseconds, or nearly a thousand times faster than you can blink your eye.

When markets move so maniacally fast, and firms like Galleon seem to have such an informational edge, how can small investors possibly stand a chance? The game seems rigged to favor the hyperactive giants of Wall Street.

In one sense, that is true. If you try to play Wall Street’s new game on Wall Street’s terms, you will probably come off the field on a gurney. But you are under no obligation to churn your own portfolio just because other people juggle stocks for only minutes or seconds at a time. Paradoxically, their frenzy renders you a service as a buy-and-hold investor: On the very rare occasions when you do need to trade, you will be able to do so more efficiently than ever before.

Read the full article here

Do Hedge Fund Managers Have Stock Picking Skills?

Via SSRN (paper by Wesley R Gray):

I study novel data from a confidential website where a select group of fundamentals-based hedge fund managers privately share investment ideas. These value investors are not easily defined: they exploit traditional tangible asset valuation discrepancies such as buying high book-to-market stocks, but spend more time analyzing intrinsic value, growth measures, and special situation investments. Evidence suggests that the managers’ long recommendations earn economic and statistically significant long-term abnormal returns. Oddly enough, these managers share their profitable ideas with other skilled investors. This evidence is puzzling in a world where there is an efficient market for fund managers and asset prices.

Read the paper here

The Impact of High-frequency Trading

Via Knowledge@Wharton:

According to some estimates, high-frequency trading by investment banks, hedge funds and other players accounts for 60% to 70% of all trades in U.S. stocks, explaining the enormous increase in trading volume over the past few years. Profits were estimated at between $8 billion and $21 billion in 2008.

Some market observers, members of Congress and regulators are worried. Are those profits coming out of ordinary investors’ pockets? Is Wall Street’s latest qet-rich-quick scheme going to harm innocent bystanders? “I don’t think it would hurt people to become educated as to the intent of these strategies,” says Wharton finance professor Robert F. Stambaugh. “What is their effect on the markets? There is a little sense of 2001: A Space Odyssey [in that it] does kind of create an air of mistrust.”

Its defenders say high-frequency trading improves market liquidity, helping to insure there is always a buyer or seller available when one wants to trade. And so far, high-frequency trading doesn’t look threatening, according to several Wharton faculty members. Indeed, it may well provide benefits to mutual fund investors and other market participants by reducing trading costs. But at the same time, several note that not enough is known about how trading at light-speed works, whether it can be used to manipulate markets or whether benign-looking moves by different players could interact to produce a new financial crisis.

“High-frequency trading involves investors with good computers taking advantage of small discrepancies in prices,” says Wharton finance professor Marshall E. Blume. “Generally, economists think that drives prices back to where they should be…. If they bring liquidity to the market and make prices more accurate, then that’s good. Now a concern, which is hard to document, is that somehow these traders manipulate the market, which would be bad.”

Turning decision-making over to machines has not always benefited humans, notes Wharton finance professor Itay Goldstein. “People believe the crash of ’87 was caused by this kind of computer-based trading.” In that case, a vicious cycle swirled out of control as computerized trading programs dumped stocks in response to falling prices, causing other programs to do the same.

Traveling at Light Speed

High-frequency trading refers to computerized trades seeking to profit from conditions too ephemeral for a human to exploit, like a miniscule increase in the spread between bid and ask prices for a given security, or a slight price difference for a stock traded on various exchanges. Trading is so fast that some firms locate their server farms near the exchange’s computers, to shorten the distance orders must travel through cables at light speed.

Aside from being made possible by the proliferation of high-speed computers, high-frequency trading has evolved out of several regulatory changes. In 1998, the Securities and Exchange Commission’s Regulation Alternative Trading Systems opened the door to electronic trading platforms to compete with the major exchanges. A couple of years later, the exchanges started quoting prices to the nearest penny rather than 16^th of a dollar, causing spreads between bid and ask prices to narrow and forcing traders who made money on those price differences to look for alternatives. Finally, the SEC’s Regulation National Market System of 2005 required that trade orders be posted nationally instead of only at individual exchanges. This allowed quick-moving traders to profit when a stock traded at a slightly different price at one exchange versus another.

With the effects of the subprime crisis still being felt, regulators and lawmakers are especially alert to any dangers that might lurk in unfamiliar Wall Street products and strategies. Alarm bells started going off with news accounts this summer about “flash orders,” a subset of high-frequency trading that exploits regulatory loopholes to give favored traders notice of orders a fraction of a second before they are transmitted to everyone else. Flash trading has been widely condemned as giving a favored few an unfair advantage.

“Some people are getting advantages that others aren’t, and that may lead to abuse,” says Wharton finance professor Franklin Allen. “It is a form of front running.” Front running, which is generally illegal, means improperly profiting by using advance information to jump ahead of someone else’s trade. In the textbook example, a broker receives a customer’s order to buy a stock for up to $10 a share. The broker buys the shares at the market price of $9.75 and sells them to his customer at $10, cheating the customer out of 25 cents a share. Flash orders can do the same thing, much faster and more often.

Flash trading now appears to be on the way out. In mid-September, the SEC proposed a ban, and the Nasdaq market quickly moved to prohibit the practice. A number of firms that had offered flash trading to clients have exited the business. The SEC ban requires a second vote by commissioners to become final.

Because many people have been unclear about the distinction, the flash-trading controversy has triggered worries about high-frequency trading, which involves strategies that appear to be perfectly legal. In some cases, high-frequency traders test prices by issuing buy or sell orders that are withdrawn in milliseconds, giving those traders insight into investors’ willingness to trade at specific prices. High-frequency traders can also earn tiny profits, millions of times over, from “rebates” provided by exchanges to players willing to buy and sell when there is a shortage of other traders.

Read the full article here

How Do Hedge Fund Clones Manage the Real World?

Via SSRN:

Interesting paper from authors Nils Tuchschmid, Erik Wallerstein and Sassan Zaker of Julius Baer Asset Management. They suggest that hedge fund clones are broadly succeeding in replicating the investment returns of real hedge funds. At the same time, however, some clones have exhibited too much correlation with equity markets and also have raised fears among some investors about the increasing complexity of replication models, the researchers warned.

The report, which looked at 21 clones over the period April 2008 to May 2009, concluded: “Hedge fund replication products seem to deliver competitive performance relative to hedge funds. More importantly they are able to deliver this at a far lower fee level than hedge funds.”

The authors’ research found that the vast majority of clones exhibited a correlation of at least 70 per cent to industry benchmarks operated by Hedge Fund Research and Credit Suisse/Tremont. Most lost less than the typical 10-15 per cent declines recorded by the industry at large, although Wallerstein cautioned,  the relative performance of clones in a bull market remained unproven. “Shortable” clones, which allow investors to benefit from losses in the underlying industry, appear to succeed in mirroring long approaches, he added.

Read the paper here

What Is the Optimal Number of Managers In a Fund of Hedge Funds

Via SSRN: I came across an interesting academic paper from State University of New York (SUNY) professors Greg Gregoriou and Razvan Pascalau. Diversification is often the mantra of hedge fund investors, but this paper suggests that the optimal number of underlying hedge funds within a fund of hedge fund portfolio may actually be as low as 6-10.

From the Abstract:

This paper investigates the level and the determinants of the optimal number of hedge fund managers in a Fund of Hedge Funds (FOFs). The paper also analyzes the impact that this level has on the performance and the volatility of returns of the typical FOF. Several important findings emerge. First, we find that the number of underlying hedge funds (HFs) included into a FOF has a negative and significant impact on the volatility of returns but less of an impact on the actual returns. However, if we properly classify the FOFs into several larger categories of interest, we find evidence that the FOFs having between 6 and 10 hedge fund managers perform the best. On average this group of FOFs has assets under management of around $200 million. Second, further evidence shows that there is a positive relationship between the size of the FOF portfolio and the lifetime of the fund. Third, several factors that influence the number of HF managers into a FOF include, but are not limited to the amount of leverage, the redemption frequency, the size of the fund, the total number of assets managed by the FOF manager, whether the fund issues a K-1 schedule for tax purposes, the currency in which the fund trades, the geographical focus, and the strategy pursued.

From the Introduction:

Many institutional investors, having no experience in hedge fund manager selection are willing to pay the additional layer of fees of owning a pre-packaged and diversified FOFs rather than setting up an in-house FOF. The number of underlying hedge fund managers in a FOF can play a primordial role in its performance and its survival. We believe this is the first paper to our knowledge that examines the optimal number of underlying hedge fund managers in FOFs. Numerous papers have stated what the optimal number of hedge fund managers in FOFs should be, but none have used an actual dataset to examine this.

Read the paper here

Fundamental Value Investors: Characteristics and Performance

I came across this interesting working paper from the SSRN. From the first paragraph:

This paper adds to the research on the issue of market efficiency. Rather than developing a quantitative trading rule that may or may not be implementable in the real world, or examining the returns of a broad cross-section of mutual fund managers who presumably have no skill on average, we analyze 2912 hedge fund manager investment recommendations posted to the invite-only internet community, Valueinvestorsclub.com from January 2000 to June 2008. The professionals involved with this exclusive site are paid for performance and must discover inefficiently priced assets and determine if the costs of pursuing them (noise-trader risk, liquidity risk, distress risk, macro risks, trading costs, and so forth) are worth the benefits. We answer a simple question: do the value investors in our sample have stock picking skills?

Read the paper here

So Much That's False and Nutty

Here is the 16 page hedge fund letter from Howard Marks of Oaktree. It contains some pretty good insights. Below is an excerpt:

Something for Everyone

One thing that caused a lot of people to lose money in the crisis was the popularization of investing.  Over the last few decades, as I described in “The Long View” (January 2009), investing became widespread.  “Less than 10% of adults owned stocks in the 1950s, in contrast to 40% today.”  (Economics and Portfolio Strategy, June 1, 2009).  Star investors became household names and were venerated.  “How-to” books were big sellers, and investors graced the covers of magazines.  Television networks were created to cover investing 24/7, and Jim Cramer and the “Money Honey” became celebrities in their own right.

It’s interesting to consider whether this “democratization” of investing represented progress, because in things requiring special skill, it’s not necessarily a plus when people conclude they can do them unaided.  The popularization – with a big push from brokerage firms looking for business and media hungry for customers – was based on success stories, and it convinced people that “anyone can do it.” Not only did this overstate the ease of investing, but it also vastly understated the danger. (“Risk” has become such an everyday word that it sounds harmless – as in “the risk of underperformance” and “risk-adjusted performance.”  Maybe we should switch to “danger” to remind people what’s really involved.)

To illustrate, I tend to pick on Wharton Professor Jeremy Siegel and his popular book “Stocks for the Long Run.”  Siegel’s research was encyclopedic and supported some dramatic conclusions, perhaps foremost among them his showing that there’s never been a 30-year period in which stocks didn’t outperform cash, bonds and inflation.  This convinced a lot of people to invest heavily in stocks.  But even if his long-term premise eventually holds true, anyone who invested in the S&P 500 ten years ago – and is now down 20% – has learned that 30 years can be a long time to wait.

The point is that not everyone is suited to manage his or her own investments, and not everyone should take on uncertain investments.  The success of Bernard Madoff’s Ponzi scheme shows that even people who are wealthy and presumed sophisticated can overlook risks.  Might that be borne in mind the next time around?

At Ease with Risk

Risk is something every investor should think about constantly.  We know we can’t expect to make money without taking chances.  The reason’s simple: if there was a risk-free way to make good money – that is, a path to profit free from downside – everyone would pursue it without hesitation. That would bid up the price, bring down the return and introduce the risk that accompanies elevated prices.

So yes, it’s true that investors can’t expect to make much money without taking risk. But that’s not the same as saying risk taking is sure to make you money.  As I said in “Risk” (January 2006), if risky investments always produced high returns, they wouldn’t be risky.

The extra return we hope to earn for holding stocks rather than bonds is called an equity risk premium.  The additional promised yield on high yield bonds relative to Treasurys is called a credit risk premium.  All along the upward-sloping capital market line, the increase in potential return represents compensation for bearing incremental risk.  Except for those people who can generate “alpha” or access alpha managers, investors shouldn’t plan on getting added return without bearing incremental risk.  And for doing so, they should demand risk premiums.

But at some point in the swing of the pendulum, people usually forget that truth and embrace risk taking to excess.  In short, in bull markets – usually when things have been going well for a while – people tend to say, “Risk is my friend.  The more risk I take, the greater my return will be.  I’d like more risk, please.”

The truth is, risk tolerance is antithetical to successful investing.  When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so . . . and risk compensation will disappear.  This is a simple and inevitable relationship. When investors are unworried and risk-tolerant, they buy stocks at high p/e ratios and private companies at high EBITDA multiples, and they pile into bonds despite narrow yield spreads and into real estate at minimal “cap rates.”

In the years leading up to the current crisis, it was “as plain as the nose on your face” that prospective returns were low and risk was high.  In simple terms, there was too much money looking for a home, and too little risk aversion. Valuation parameters rose and prospective returns fell, and yet the amount of money available to managers grew steadily.  Investors were attracted to risky deals, complex structures, innovative transactions and leveraged instruments.  In each case, they seemed to accept the upside potential and ignore the downside.

There are few things as risky as the widespread belief that there’s no risk, because it’s only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums.  Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we’ll continue to be alert for times when they don’t.

Read the whole letter here