Equities trading focus : Technology : Joseph Hipps

Joseph HippsTOWARDS ALPHA PRESERVATION.

Investors could reap significant benefits from technology that brings realised returns into closer alignment with expected returns. Joseph Hipps, head of client service and support at Trade Informatics explains.

In the early days of telecommunications, the clarity of voice transmission was often eroded by the physical distance between callers, to the extent that long-distance calls were sometimes barely even audible. Advances in the technology that supports the phone system have ironed out those kinks over time, and users can now communicate much more easily across continents with little deterioration in quality. A similar kind of transformation is underway in asset management and order execution.

Many investors currently face a frustrating situation in which their expected paper returns greatly exceed their realised returns, largely because of the costs incurred from slippage of information during the order handling and execution process. Investors should be empowered to recoup those costs, and technology can be used to minimise the loss of returns.

Consider the technology stack associated with a typical client trade today. At the top of the stack is the portfolio management system, into which a portfolio manager or investment analyst enters the details of a transaction. At this point, the portfolio manager has a trade idea, usually driven by a clearly defined alpha generation strategy, and is still calling the shots.

But when the trade idea passes to the buyside trading desk, it flows into an order management system, and the alpha profile of the manager is largely lost. Then, when the trade moves into an execution management system, its key characteristics are rewritten into FIX messages so that they can be clearly understood by the sellside. While the messaging is highly effective, the original decisions that accompanied the trade idea have by this point been completely lost.

Quantifying lost returns that may be caused by the passing of an order from one investment agent or system to another is not an exact science and will naturally vary depending on the size of the order and the nature of the parties involved. But there is no doubt that ‘transmission decay’ imposes a significant cost on the end investor.

Much like the early users of telephones who conceded to an inevitable loss of quality when trying to make contact with faraway relatives, investors may well feel there is no way to avoid this transmission decay. If they want to execute an order using available technology, the order has to pass between multiple agents and systems, and that in turn will have some unavoidable impact on the bottom line.

But there is no need to admit defeat so quickly. While it may not yet be widely practiced, it is possible to apply a technology wrapper around all three systems that will preserve the alpha profile of the order as it passes between agents, and continually assess the trade-off between short-term return and incremental impact.

This kind of alpha preservation solution can be tailored to meet the needs of end investors. An active fund manager that has powerful market intelligence, for example, might need a very aggressive logic that could quickly adapt to changes in market conditions, while a more passive strategy might extend the duration of orders with much less intervention.

In practical terms, an order is paired to a specific alpha profile at the outset. This alpha profile is then used to parameterise the order when it moves into the order management system, and those parameters are in turn used to create FIX tags that can be recognised by the execution management system and the sellside. This means that the link between the original profile and the execution strategy is never severed.

Without this alpha preservation solution in place, portfolio managers can be as prescriptive as they like in the early stages, but ultimately they have to accept that their orders will be shoe-horned into off-the-shelf execution strategies that may result in drastically different returns from those that had been calculated and expected.

There are inevitable challenges in realising effective alpha preservation, not least the fact that buyside firms will not want to share all of their historical data with counterparties, particularly if there is any competitive risk for either side. Alpha profiles have to be designed and delivered by independent third parties that have access to the necessary data and expertise, in order to map diverse execution strategies into each of the three systems.

The barriers to entry for providers of this technology are high. Effective delivery depends on a sophisticated understanding of the investment technology stack, the execution process itself, and the alpha profile of individual investors. Dealing with the diverse characteristics of multiple order management systems and being able to create a synthetic language that interacts with each one is also a prerequisite.

Ultimately, mapping the proprietary language of each of these systems into FIX messaging so that the alpha profile is not lost when it crosses to the sellside is the key to alpha preservation, with the overriding objective being to identify, retain and make use of portfolio decisions throughout implementation.

This nascent technology has the potential to transform the investment management process in the same way that fibre optics revolutionised telecommunications and vastly improved the user experience. If investors are really to close the gap between realised and expected returns, they need to embed alpha preservation at the heart of their operations.

Click here for the Tradeinformatics website.

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