Department of the obvious on Asset Management, HFT and Data…

Who knew that owning too much of an asset might not be a good thing?

Under the heading of “The department of the obvious”, institutional Investor reports on a study from Duke that “proves” diminishing returns as funds grow in size.   What I find amazing about this isn’t the finding, which is well known, but rather that the article doesn’t use this to draw several key conclusions:  First, the most important: Active  managers should integrate trading & expected trading costs into their portfolio construction methodology.    As I have pointed out in previous posts, all assets have an optimal position size, determined based on projected alpha AND the cost of entry and exit to the position.   The steadfast refusal of most funds to integrate trading, portfolio construction and asset selection via quantitative tools is the problem, NOT the success of the marketing department…. Second, fund size is an ADVANTAGE to passive funds due to their ability to use size to create economies of scale, so active managers should adopt passive methods rather than oversize their individual positions.   While this would “dilute” their alpha (and require lower fees as I explained in my “Captain Kirk” article, it would, however, allow funds to grow their assets while continuing to deliver outperformance.  Third, it shows how awful the pension consulting industry is.  Most consultants fail to assess individual asset siize constraints or evaluate the entire investment and trading PROCESS into their reviews or recommendations.  As a result, they are almost guaranteed to fail their clients when they use past performance as the backbone of their recommendations.  It’s no wonder that the FCA lost patience and blasted the pension consultants in their recent report.

More from the department of the obvious, about HFT…

Bloomberg’s latest HFT article blends reporting on the fact that volatility has been at a cyclical low while the disruptive advantage of new technology has succumbed to competition, to keep alive the mythology of HFT.  Their claim that “the cutting edge of market making is high speed data transmission” with microwaves, etc is not true.  The reality is that market making, agency algorithmic trading, statistical prop trading and order routing all leverages some high speed technology.   The cutting edge of market making today, as it is with many investors and traders is actually DATA and machine learning techniques.  Market makers do need to stay as fast as their competition, but they are focused on incorporating more signals into their processes for fast determination of the “fair value” of all the assets they trade.  Speed is necessary, to avoid being caught with too much risk, but every market maker I know, would prefer it if all the exchanges were in one data center with one level of co-location service.  THAT would cut the extremely high fixed costs of trading infrastructure, which has continued to climb, even as volatility has fallen with share volumes stagnating.  (which was the important and accurate part of this article)

Yet more from the department of the obvious, about DATA…

CNBC coverage on the importance of data, in the world of hedge funds is standard reporting of how important data analysis is in the industry.  It is fairly obvious that quantitative and “tech aware” asset managers want to leverage these emerging technologies, since they represent a more efficient way to implement many of the strategies that managers used to use based on anecdotal evidence.  The real question is why it is slow to penetrate the “long only” asset management industry…

Lastly, Fixed Income is getting looked at…

The house holding a hearing on fixed income market structure is interesting, but my fear is that the naïve notion of expecting fixed income to trade more electronically (like equities) will be featured.   There are valid reasons why fixed income can’t trade the same as equity in general.  First, the liquidity is vastly different.  Corporate Bonds, for example, trade almost 2 full orders of magnitude (100 times) LESS than equities per dollar of enterprise value.   This conclusion derives from data suggesting that 70% of all trading for an average corporate bond is consummated during it’s primary issuance; leaving 30% of the bonds trading to happen over its (average) 10 year life.  That compares to an average turnover of 0.5% of each individual equity securities market cap per day….  Second, fixed income traders are often an extension of the alpha generating process at funds.  Most purchases are done based on general guidelines of type of bond, credit, duration and sector characteristics, where the trader looks for the best value offers in the market.  That compares to equities, where traders work firm orders for explicit quantities of individual stocks.  All of this means that the approach to improving fixed income market structure should focus on information and transparency, not trading mechanics…



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