Category

Insights – Financial adviser

Geeks and Flash Boys – The Importance of Understanding Trade Execution

By Insights - Financial adviser

Most advisers and wealth managers have placed listed investment trades at some stage in their career. Consequently most are aware that trade execution can have a big impact on price, particularly when it comes to larger or illiquid orders. In fact, poor trade execution can mean the different between strong investment performance and a poor outcome. This is why a whole section of the finance industry is dedicated purely to trade execution. In this note we explore this topic, why it is important, and what it can mean for investment returns.

The Basics

When it comes to executing a listed trade the quickest and simplest way is to sell into the best bid, or buy the best offer, as quoted on the listed market. This is known as “crossing the spread”, however on the balance of averages it comes with an immediate cost (in addition to brokerage), being the price differential between the best bid and offer. For small orders in large liquid companies this cost is usually small. However the larger the order (or the more illiquid the stock) the more likely there won’t be enough volume to fill the entire order at the best quoted price on the other side. Meaning you must accept a poorer price as your trade moves through the quoted price levels.

Rise of the Geeks

Given large funds need to execute large orders this poses a problem, as their trades will inevitably impact the market. This is where the resident geeks at sell-side (broker) investment banks come to the fore. By creating “algorithms” that, in most cases, essentially drip feed the orders into the market over time, overall impact can be greatly reduced. However it is a delicate balancing act…the longer it takes to drip feed the order, the more chance the stock has of moving away from the intended purchase/exit price. The optimal answer therefore involves complex math’s equations with a number of inputs, including the urgency of the order and the historical price behaviour of that particular stock.

Rise of the Flash Boys

Whenever you have clever people trying to outsmart a market, you will have people who are even more clever trying to outsmart them. This is where the “Flash Boys” come in. Also known as “high frequency traders” or “HFT”, these guys build algorithms that are designed to “game” the sell-side algorithms, essentially creating a geeks arms race. A simple example of a common HFT strategy is for them to work out when a broker algo is buying a large order, then purchase some of that stock ahead of that algo. They then sell it back to the algo at a more expensive price. All of this can take place within the blink of an eye. In fact these strategies can be so lucrative that in some cases HFT firms pay stock exchanges big bucks to have their computers “co-located” at the stock exchange office, so that the physical length of the cord between the HFT computer and the exchange is as small as possible, giving their computers a speed advantage. The sell-side brokers of course try to defend their algorithms against HFT, but sometimes with only limited success. Michael Lewis’s entertaining expose, “Flash Boys” 1, examined this side of the market and the lengths that some of these firms will go to obtain an advantage.

There are other options to help reduce market impact and the predatory actions of the Flash Boys, such as “block crossings” and “dark pools”, but these avenues come with their own pitfalls and would require a whole piece on their own to delve into.

Meaningful impact on returns

While the above makes for entertaining (if slightly nerdy) reading, understanding trade execution is important. Especially as it is up to the fund manager or investor to decide the best way to execute their order. While institutional sell-side brokers will provide the algorithms, each algorithm has its own distinct features. Not all algorithms are created equal and they all come with trade-offs. Having spent some of my career on the algorithmic trading desk of a large investment bank, this is something that I am acutely aware of.

Getting it wrong, particularly for larger fund managers, can have a big impact on returns. It must also be understood that some degree of market impact cannot be avoided, particularly for the larger funds. This is why hedge funds often close their doors to new money once they reach a certain size. When it comes to trade execution smaller funds are at an advantage, as being more nimble means being able to get in and out of holdings with minimal “slippage cost”. Something to keep in mind when selecting an investment manager.

Murrough O’Brien, former head of Electronic Trading at Citigroup and former board member of the Stockbroker and Financial Advisers Association and Chair of their Institutional Committee put it this way. ”Sophisticated trade execution has become a vital part of today’s investment process…utilising all of the tools that a trader has in their arsenal, from algorithms and transaction cost analysis to executing on different trading venues, truly differentiates funds with good performance from those with exceptional performance. Execution is also in the cross-hairs of regulators globally at the present time and with the emergence of MiFID II in Europe and RG97 in Australia. The need for funds to achieve “best execution” for their clients has never been more important.”

References
Lewis, M, 2014, Flash Boys: A Wall Street Revolt, W. W. Norton & Company, US.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

The Right Number of Stocks for Portfolio Diversification

By Insights - Financial adviser

When it comes to constructing a direct equities portfolio a common dilemma faced by investors is the decision around how many stocks to include. Too many can make a portfolio harder to monitor, can increase transaction costs and can often be interpreted as a lack of conviction. Too little and a portfolio risks being over-concentrated, unnecessarily volatile and can contain risks that could easily have addressed via diversification.

As with most things in life, the first thing to consider is what are you are actually trying to achieve. If you are looking to track and potentially outperform a specific benchmark index, then a larger number of stocks is generally going to be required. However, if you are less “benchmark aware” and are more focused on simply reducing volatility whilst maintaining conviction on your stock views, then a smaller number will be needed.

Putting some Numbers Around It

Academic studies² have shown that if your aim is simply to reduce risk, measured in terms of portfolio volatility, then holding as little as 20-30 equally weighted positions can provide 90% of the diversification benefit as owning the whole index. Diversification beyond that number only provides a limited and diminishing level of benefit, as shown in the chart below:

 

 

On the other hand, if your portfolio is heavily benchmark aware it will take a much larger number of equally weighted holdings to address your “risk”. This is because risk takes on an additional dimension. Not only are you trying to reduce overall volatility, but you will also want to manage the performance risk relative to the index itself. A study by Surz & Price shows that upwards of 60 equally weighted holdings are needed to significantly reduce risk that incorporates “tracking error”. The cost of course of holding such a large number of stocks is that it inevitably means including companies over which you have much less conviction!

True Diversification involves more than a min number of holdings

While the number of holdings undoubtedly impacts portfolio risk, true diversification is more about how the holdings within your portfolio behave relative to each other. For example, constructing a portfolio that consists of the 20 largest Australian “blue chip” stocks weighted according to their market cap (size) may seem like a sound investment strategy and one that would help address tracking risk. However in Australia, this would mean allocating over 48% of your portfolio to the Financials sector, with less than 18% in total allocated across important sectors such as Industrials, Healthcare, Energy and Consumer Discretionary companies. The graph below shows how a portfolio constructed this way at the start of 2017 would have performed vs the ASX200 Index over the period since:

 

 

It goes without saying that companies within the same sector are more highly correlated than those that are not. The impact of the Royal Commission on the Financials sector being a case in point! In this case not only did the “top 20” portfolio significantly underperform over this period, but it also exhibited considerably more volatility.

A number of considerations

In summary, diversification is an extremely important ingredient when constructing a direct equities portfolio. It is no accident that it is known colloquially as the only “free lunch” in finance. However, it’s important to be aware that there are a number of factors which play a role in diversification, from the number of holdings to the correlation of the individual assets themselves. This is where professional investment tools that enable investors to understand and quantify these sources of portfolio risk and expected return can play such an important role. Finally, it is important to consider the objective of the portfolio itself and the investor’s tolerance for volatility, both in absolute terms and in reference to the index benchmark.

References

  1. Surz, R, Price, M, 2000, ‘The Truth About Diversification by the Numbers’, The Journal of Investing, Winter 2000.
  2. Vitali A, Francis T, 2012, ‘Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets’, SSRN, November 29, 2012

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Interest Rates and Investment Portfolios

By Insights - Financial adviser

Global interest rates are on the rise, so what are the implications for investment portfolios? To answer this key question, we look at not only the pecking order of interest rate sensitivity on each asset class (otherwise referred to as “duration” risk), but also the sensitivity of various sectors within the equity market.

The Yield Curve: the market for interest rate expectations

In quantifying the market’s expectations for interest rates into the short, medium and long term, the yield curve is an essential guide to a shifting rate environment. This is because the yield curve reflects the expectations of the market in aggregate in terms of where interest rates are headed. A “normal” yield curve is one that is shaped in a convex fashion, effectively showing that longer maturity bonds have a higher yield compared to shorter-term bonds. This makes sense due to the risk associated with time. However also factored into the “curve” are interest rate expectations looking into the future.

Over the last 12 to 24 months we have seen the yield curve in US shift upwards, a reflection of progressively increasing expectations of future rate rises. Even in our domestic economy, we inevitably see increasing upwards pressure to our yield curve, as the currency comes under pressure and the RBA is forced to act in order to protect it.

 

 

Asset Class Implications

In assessing the implications at the asset class level, we need to consider the “duration” of various competing investments. The basic concept is, the more fixed and predictable an assets cashflows, the greater the duration, and the further the asset has to fall in a rising rate environment.

At one end of this scale, if we had locked in a fixed annuity payment of exact cash flows over the long term, we would have most to lose; while at the other end of the scale, if we have a small cap mining stock of uncertain and unstable cash flows, we would have little to lose given its valuation is more associated with its growth expectations.

While this may sound counterintuitive, that is, the more defensive the asset the greater the potential downside in many cases, it makes sense when you consider that fixed cash flows are worthless in a rising interest rate environment. This is because inflation is usually increasing and money can be invested elsewhere at better rates.

 

 

Direct Equities Implications

Equity portfolio managers need to think about how this new interest rate regime translates to their portfolios. Again the key here is to identify which assets have the most certainty and stability around cash flows, and hence have most to lose under a rising rates scenario.

 

 

Positioning Portfolios

Interest rates are just one very important variable likely influencing portfolios over the medium to long-term. It is also worth remembering that this effect is only one variable of many that are likely to play out. Changes in interest rates are also in the context of the global macro-economic environment, and this will inevitably include prospects for all the major economies, particularly the US and China, commodities, the Australian Dollar, credit market conditions, and so forth.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.

Advice not the only sector under pressure

By Insights - Financial adviser

With the spotlight shining so intensely on financial advice at the moment, one could be forgiven for thinking that it is solely this end of the asset management industry facing wholesale regulatory driven change. However Fund Managers and Institutional Brokers are also facing their own pressures, which could have significant read-through for their businesses and for the nature of financial markets as a whole.

International forces at play

While most of the change in the advice sector is being driven by domestic forces, the pressure at the broker/fund manager end is being driven by international regulation. On 3rd Jan 2018 the EU implemented the latest tranche of its “Markets in Financial Instruments Directive”, otherwise known as MIFID II.

One of the key components of this legislation is that it forces fund managers to separate out the fees they are charged for research vs those charged for trade execution. You may ask so what? Well traditionally fund managers have paid for both research and trade execution via a single bundled fee, paid for out of the fund itself…that is, it was paid for by the end investor. In the view of the EU, this lack of transparency meant that investors were often being ripped off, as large annual sums were paid to investment banks and brokers for often questionable value-add. The long and short of the change is that it is forcing fund managers to become significantly more accountable for their research spend, reducing the amount of money going into the pockets of investment banks globally for research.

It is also important to point out that while the changes are European driven, they impact most global fund managers, therefore the impact itself is global. There is also an expectation that sooner or later the same regulations are likely to be adopted globally.

Why this matters

With less money flowing to institutional brokers many investment banks have already started shrinking their research departments. If this trend continues, and there is all likelihood that it will, the number of sell-side analysts covering each sector will shrink considerably. Not only that, but the brokers that remain will become increasingly sensitive as to who they share their research with. For example, UBS recently withdrew its research from Bloomberg as a result of MIFID II, in order to gain more control over who can access it.

While the stated aim of MIFID was to protect the end investor, there is a real possibility that the actual effect will be to make markets less efficient, as a smaller and smaller percentage of market participants have access to high quality research. The impact is likely to be exacerbated by the rise of ETF’s, as more and more capital is invested without reference to company specific analysis of good quality.

For the first time in a long time, the pendulum may be starting to swing back in favour of using active managers with access to quality investment research over passive and semi-passive strategies. In our view, having a detailed understanding of the pros and cons of active vs passive management and when to use each remains a key component of constructing an optimal investment portfolio.

Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.

Disclaimer: The Information within this article does not constitute personal financial advice. In preparing this document, Resonant has not taken into account your particular goals and objectives, anticipated resources, current situation or attitudes. You should therefore consider the appropriateness of the material, in light of your own objectives, financial situation or needs, before taking any action. You should also obtain a copy of the PDS of any products referenced before making any decisions. The data, information and research commentary in this document (“Information”) may be derived from information obtained from other parties which cannot be verified by Resonant and therefore is not guaranteed to be complete or accurate, and Resonant accepts no liability for errors or omissions. Resonant does not guarantee the performance of any fund, stock or the return of an investor’s capital. Past performance is not a reliable indicator of future performance.