The rise of passively-managed funds is changing the nature of liquidity in the US equities market and forcing trading tactics to evolve accordingly, says financial research firm TABB Group.
The research, ‘US Equity Trading 2011-2012: Coverage under Fire’, reveals persistently volatile market conditions during 2011 have added further challenges for US buy- and sell-side firms and encouraged a deep rethink of trading strategies. The survey, which consulted 68 long-only head equity traders at US asset management firms, found concerns about market quality and being gamed by high-frequency trading firms, rated highly.
“The buy-side faces a daily battle against market mayhem that has reset the needle on the dial of normality in a marketplace where only unpredictability is certain,” said Miranda Mizen, TABB principal, director of equities and co-author of the report.
In an environment where it is increasingly difficult to pick stocks, a long-term rise in investment in passive funds, such as index funds, is encouraging smaller order sizes spread across more stocks. At the same time, correlation of stocks is increasing, as securities are often bought together as baskets of stocks via indices.
Mizen explained that if there was sufficient volume to produce prices at multiple levels in the market, the most efficient solution for some firms was to work their order through the day and slice it into smaller pieces, using an algorithm to trade. This creates new trading patterns, with increased trading at the end of the day – a feature especially pronounced for exchange-traded funds.
In addition, while trading algos may be popular, Mizen suggests that the type of algos being used and the parameters they are using are often heavily monitored and controlled by human operators, creating a hybrid of low- and high-touch trading methods.
“There is more of a tendency to use every tool in the toolbox more,” she told theTRADEnews.com. “The combination of the widest range of tools possible will help firms trade better, using more strategies at once.”
Not all firms agreed that volatility would convince them to change their trading style. In the TABB survey, some 53% of respondents answered that volatility itself would not cause them to change the way they trade. Nevertheless, respondents were keen to stress the importance of using unpredictable algos as a means to combat gaming, whilst many rated a better understanding of algorithms as one of the best defensive measures.
Priorities identified for 2012 included consolidation of algo providers and rewarding brokers that provide innovative products and blueprints of how their algos and smart-order routers work.
“Algos that can think in blocks while trading in a way that adapts to market conditions – this is what many are striving for,” said Mizen. “The next generation of algos will bring a new level of smartness to bear. The volatility we have seen over recent months makes for a difficult environment to trade, but intelligence and resourcefulness will be key.”