Can you tell us about Aurora Funds Limited and the Aurora Absolute Return Fund – for which you are the trader and portfolio manager?
Aurora Funds Limited is an Australia-based funds management business listed on the Australian Securities Exchange. I manage the Aurora Absolute Return Fund, a market neutral strategy that invests in Australian listed equities using equity derivatives, including options and convertible securities.
The strategy is to apply fundamental and quantitative analysis to event situations such as IPO listings, takeovers and mergers, de-mergers, restructures, liquidity events, recapitalisations, multiple share classes, option availability and pricing. Currently, the fund manages around A$130 million.
What are your main priorities and challenges?
My priority is to deliver consistent risk adjusted returns to our investors. Our long term aim is to deliver 5-10% above cash per annum with low risk, which we believe is best achieved using a multi strategy approach.
Our options strategy delivers well during market dislocations whilst the other strategies typically outperform under normal market conditions.
Understanding a stock’s liquidity and speed of execution in fast changing markets is critical to our operation, which is why the fund’s three portfolio managers also perform the role of trader.
How is the desk set up?
Our team sits on an open-plan desk with a free exchange of information and ‘dealing room ears’.
We believe this brings significant competitive advantage in terms of fostering responsibility for trade and fund performance and the quality/speed of execution.
Speed is significantly enhanced and information tightly applied. Each trader is responsible for all aspects of the order life cycle, and while we conduct regular formal meetings, nothing can replace the live exchange of information, be it relating to global market conditions, the overnight performance of global sectors/equities, new strategies, position sizing, new positions, desired rate of returns on positions, broker performance, settlement issues, option market volatility, liquidity in takeover stocks, spreads on convergence trades, and borrow available.
Our trading approach is short term in nature, so to effectively communicate desired entry/exit points to a dealer on a daily basis would be very time consuming. We are liquidity takers, so we are primarily concerned with entering a trade at the correct price for the correct rate of return, not for the sake of being fully invested. Speed to market is equally important for entering and exiting trades. Where circumstances for a trade change, we like to exit as quickly as possible. Not having to refer price points and volumes to a PM/Investment Committee certainly helps this process.
Observing market movements and sales trader flow can enhance the return matrix as it gives us a better idea of where we can achieve best execution.
We run live and delayed risk systems with built in redundancies. Independently researching each position is very important; there is a lot of noise we sift through. Optimal information and execution venues change rapidly and we spend a lot of time interacting with service providers and brokers. The PM/trader function does present risks which means we rely on pre-trade compliance from brokers and utilise an extensive post-trade compliance system.
How do you break down responsibilities within your team of PM/traders?
Individuals have built up skill and preferences for certain position types. Once again the live exchange of information is very helpful. A market situation arises, the team discusses the event and we will agree on a PM/trader for that position based on experience in that strategy or particular name or sector. This is constantly evolving. I initially started with an interest and concentration in options and convergence trades.
A few years ago the yield strategy presented new opportunities which meant we decided to merge trader responsibility across yield instruments and option trades. So, a trader responsible for a CBA yield instrument also manages the CBA option book. Likewise M&A trades have tended to allocate towards traders with a preference for that sector.
Each trader has at least one option position as the options market is a good barometer for risk.
What issues do you face when creating and trading short positions?
Shorting requires borrow locate (the shorter borrows the stock from a current holder through an intermediary, for which the shorter pays a fee).
Before one can approach a decision to short a stock, availability of borrow needs to be considered. This encompasses current availability of the stock, borrowing rates and future availability of the stock.
Many good short trades get wiped out quickly when borrow is recalled. Often we decide not to enter trades where we feel the possibility of borrow recall is high. This is particularly relevant when trades involve illiquid stocks.
The majority of our short trades are in hedged options positions. These are typically large cap, very liquid stocks with ample borrow. Care is still required to ensure that rates are at best price. In Australia particularly, domestic borrow is not desirable due to dividend tax considerations.
From an execution point of view, shorting is no different to selling a stock that you own. You are selling a stock to achieve a particular economic outcome.
Speed to market is important. We can be shown good size to sell in a trade where we need to interact with stock borrow desks and brokers quickly in order to ensure we can take attractive liquidity.
What is your relative usage of high and low touch channels?
Around 80% of our trades by volume are through low touch venues. These are typically hedging trades and high volume trades where low brokerage is important. The actual dollar value of trades is markedly higher (towards high touch) and varies with market type.
What is your use of CSAs?
Given our reliance on independent information sources and quality management and risk systems we utilise CSAs fairly extensively. Our use has increased over time and we have found significant value in this as markets have become more automated and significant real flow concentrated in the hands of a few brokers. CSAs have been very effective in ensuring best execution and independent research.
What is your approach to transaction cost analysis?
We use TCA extensively to ensure we are achieving our return objectives.
The TCAs we use differ from traditional models we are presented with. We have a cash benchmark and, as such, the TCA is used to assess entry/exit point of a trade based on desired entry/exit points.
The performance of an algorithm versus VWAP is of little value to us, however the performance of VWAP vs a liquidity seeking strategy vs interacting with a sales trader is of high importance in assessing trade opportunities as well as actual performance.
Some of the analysis is anecdotal. A good current example would be the trend in volumes towards close. Light volumes on open create additional volatility and large volumes on close create good hedging opportunities. We have desired rate of return and entry/exit points for each position. This is merely a case of making sure that we use the best available execution strategy on open (typically an aggressive liquidity seeking algorithm) and closely monitoring the screens and high touch flow on close.
What kind of technological developments have you overseen?
On joining the business in 2006 our back office was outsourced. My task was to bring this in-house and automate reconciliation processes.
As is the case now, post trade compliance was of the utmost importance. Each trader has spent time in the back/middle office interacting with custodians, and understands the value that back/middle office functions bring to the whole investment management process, from an in-house, service provider and custodian perspective. Our back/middle office software is largely bespoke as a result of several years of tweaking. The risk principles have remained the same.
The business was an early adopter of DMA – which predates me. There is a culture of independent research and idea generation and, as such, we are free to explore ideas/opportunities as we see fit. As such, I largely oversaw early adoption of algorithms for equities execution and automated options execution. We continue to explore alpha generating automated trading opportunities, but have not found a trading strategy worth implementing.
What observations do you have on the algorithms you use and how do you differentiate algorithm providers?
I think the algorithm suite is now largely homogenised across the brokers. For us, the true edge is now delivered in routing orders across multiple liquidity venues with little market impact which will give us price improvement at a desired entry or exit point.
Extensive use of TCAs, in the traditional sense, and having a ‘clean’ dark pool is not important to us.
What is your approach to finding liquidity in hard-to-find stocks, or in less liquid markets?
Our model runs on a liquidity-taker basis and, as such, we try to avoid situations where liquidity is hard to find.
Nevertheless, where we do find liquidity issues we will approach several different venues for liquidity. For example, in an illiquid takeover situation, we may approach a high-touch broker who we believe may have liquidity from long-only clients. Failing that, we will seek liquidity on electronic venues. We are plugged in to every liquidity venue on the market.
What are your thoughts on relevant market microstructure and regulation that affects your trading?
I think the changes to crossing rules have reduced ‘real’ volume on the lit market and increased block size trading i.e. advantage institutional investors over retail. They have also reduced opportunities for high-frequency trading, but ultimately the average retail investor is negatively affected.
The net result for us is largely the same. Previously we were able to obtain price improvement through bid/offer priority, now we have a competitive advantage through block trades.
I don’t think there are any significant issues with equity market microstructure at the moment. The regulator has done a good job in preserving and policing lit and dark market functions, and hopefully going forward, it avoids regulation for regulation’s sake.
The exchange-traded option market microstructure has undergone some improvement recently, but fell short of where it needs to be to see an increase in “real” institutional flow on the market. Many institutions still prefer transacting OTC for options; this is a lost opportunity for the ASX which I hope they rectify.
How do you go about picking a sell-side broker panel for trading and execution?
As a liquidity-taking manager we are happy to be plugged into all brokers and venues. We do caveat this with advice that we are not particularly interested in sell-side research. Given certain key relationships we do have an expectation of which brokers we will interact with more. We are not bound by a strict panel guideline, which we think is a competitive advantage.