While the volume-weighted average price (VWAP) algorithm has been a mainstay of the buy-side’s trade execution arsenal for many years, it appears many traders are now turning their backs on an old favourite. Algorithm providers are reporting a sharp decline in their clients’ usage of VWAP tactics.
“The usage of VWAP among our clients has declined significantly,” says Peter Howard, head of equities at agency broker Instinet Europe. “From January to December last year, VWAP fell from 33% of our clients’ algorithm usage to 5%.”
The simple reason is that VWAP is poorly-equipped to cope with the difficult trading conditions that have prevailed since the collapse of Lehman Brothers in September last year. Since then, markets have been extremely volatile, and traders have often had to cope with extreme intra-day shifts in stock prices and benchmark indices.
In these conditions, traders need to execute very quickly to maximise the chances of getting close to the prices they see on their screens and minimise the risk of being stung by a sudden and unexpected price move.
This environment is incompatible with VWAP algorithms for several reasons. Firstly, they are typically employed to work an order over an entire trading day rather than react quickly to capture specific prices. Secondly, in a market that renders benchmarks meaningless, algorithms that try to achieve or beat benchmarks are of little use. Thirdly, the algorithms’ reliance on historical volume curves and data makes them unsuitable for dealing with a period of unprecedented stock price swings.
“Shorter duration algorithms are getting more use,” says Ashok Krishnan, managing director, execution services at broker-dealer Merrill Lynch.
Another phenomenon seen in recent months has been shrinking liquidity on order books. This, coupled with the increasing fragmentation of liquidity across both displayed and non-displayed trading venues, means the buy-side is having to work harder to fill orders. VWAP algorithms provide little help in this regard, because they are designed to hit a price-based benchmark rather than seek liquidity.
But it would perhaps be unwise to write off VWAP algorithms completely. While the buy-side may be making less use of their VWAP algorithms, they are certainly reluctant to throw them out.
Those asset managers who buy and hold stocks for long periods of time, for example, and who are less sensitive to intra-day price shifts, could still find them useful. “As a trading strategy, people think it is still a very good and fair way of allocating your business over a period of time,” says Rob Boardman, head of algorithmic sales at agency broker ITG. “If you are a passive manager or your trade has no obvious alpha content, it is probably as good a choice as any.”
Also, with some tweaks, the algorithm can be put to work in current conditions. For example, some are using VWAP over shorter timeframes, customising it where possible or combining it with other algorithms to achieve the desired effect. A trader might use a VWAP algorithm for part of the day, but switch to a more aggressive strategy if the price starts moving adversely.
VWAP and other passive strategies could also enjoy a renaissance once the current financial crisis has subsided and trading conditions return to something approaching their pre-September state. But while they may make a comeback, they are likely to look very different from their old selves.
“There won’t be a complete return to passive strategies because the marketplace has changed dramatically,” says Owain Self, head of European algorithmic trading at investment bank UBS. “In order to minimise market impact people do need to use these more passive algorithms, but they need to add sophistication to them by bolting on a liquidity seeking element and making sure they don’t miss opportunities.”
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