Putting Mutual Funds on Equal Footing with High-Speed Traders
July 15, 2011
In a world where the minute, second and even millisecond that you pull the trading trigger can materially affect the return you get, managers of mutual funds too often are slow to buy when prices are rising and too fast when prices are dropping.
That’s the result of a study of thousands of orders in a two-year database of stock transactions in the United States, executed by Pipeline Trading Systems, a supplier of tools to institutional trading desks. The company analyzes high-frequency trading techniques and how they affect mutual funds.
“On average, when the market dictates the rate of your execution, you will tend to trade too fast, when it’s detrimental, and trade too slow when it would be better to trade quickly,” said Pipeline Chief Executive Fred Federspiel.
The study found that trades that had the best return over the first three months of their lives were executed much slower than average. Meaning: Gains were left on the floor, because of slow reaction.
And the trades that ended up hurting the funds the most on that three-month time scale were executed much faster than average. Meaning: Institutional traders took bigger hits than they should have, if they could have a better idea of which way a given stock was likely to move in that time.
What’s driving that effect is the success of high-frequency traders. They are able to make these short-term predictions, Federspiel maintains.
“They deliver liquidity into a market at a high rate, when it is not good for their counterparties,” he said. “And starve the market of liquidity when it would be good to trade quickly.”
This is “adverse selection,” high-frequency style. And Pipeline is trying to put mutual funds on an equal footing, with one new measurement benchmark and, separately, a tool that lets institutional traders project what’s likely to happen during a trading day for a particular stock.
Then, that tool makes a buy or sell recommendation, suggesting how fast to move. Finally, it gives the trader a chance to either “fast forward” the execution of the trading decision as events unfold or, if so desired, swipe all existing liquidity out of the market, in one fell swoop.
The measuring stick is something called a “momentum-adjusted cost benchmark.”
The benchmark estimates the impact on the price of a stock if an institution moves on it, adjusted for the underlying momentum in the stock that already exists. Then it adds onto that a computation of the short-term gain or loss in the stock, after the impact is removed.
So, over time, users get a sense of which trading strategies have worked and which haven’t. “It does help you identify trading techniques that are subject to more of this high-frequency trading adverse selection,” he said.
That allows a firm to weed out either trading methods or traders themselves that have tough times coping with the effect of high-frequency trading tactics.
Its Alpha Pro tool, introduced last year, takes the process and looks at hundreds of statistical factors that influence stocks.