Profit seeking. Active portfolio managers seek to outperform their benchmark (trading securities they believe to be mispriced.
- Managers need to act on their insight before the rest of the market; hence, a key consideration is the rate of alpha decay. Alpha decay is deterioration in alpha once an investment decision has been made.
- To minimize information leakage, managers may execute their trade in multiple venues. This may include less transparent venues called dark pools, which are trading systems with low pretrade transparency.exchanges are examples of lit venues.
Risk management and hedging needs. Portfolios need to be traded to maintain targeted risk exposures. This may be simply rebalancing the portfolio after a change in market conditions, or hedging to remove a risk factor from a portfolio.
Cash flow needs. These trades are primarily caused by investor subscriptions into, and redemptions out of, the fund.
- The urgency of the trades depends on the nature of the cash flow, the liquidity of fund investments, and the liquidity terms promised to fund investors.
- Funds with less liquid holdings will find it difficult to invest new client funds in a short time frame. This may lead to cash drag, where the low returns of cash cause the fund to underperform the benchmark.
- To avoid cash drag, a manager may engage in equitization strategies where liquid securities such as exchange-traded funds (ETFs) or derivatives are used to gain market exposure while the investment in underlying securities occurs over time.
Corporate actions, margin calls, and index reconstitution.
- Corporate actions on portfolio holdings such as mergers, acquisitions, or spinoffs may require portfolio trading.
- Margin calls on leveraged positions as well as derivatives positions that are suffering losses may require urgent sales of portfolio holdings.
- When the benchmark index is reconstituted, managers may need to execute trades to reflect the change.
Once the decision to invest has been made by the portfolio manager, the executing trader and the portfolio manager must work together to identify the optimal trading strategy given the manager’s objectives. Key factors that dictate the appropriate trading strategy are (1) order characteristics, (2) security characteristics, (3) market conditions, and (4) individual risk aversion.
Order characteristics. These include side, absolute size, and relative size.
- Side refers to the direction of the order.
- Absolute size refers to the number of securities being traded. Larger orders will have a higher market impact cost than smaller orders.
- With relative size, managers will often consider order size as a percentage of average daily volume (ADV). Orders that constitute a higher percentage of ADV are expected to have higher market impact costs.
Security characteristics. These include security type, short-term alpha, price volatility, and security liquidity.
- Security type. Different security types trade in different markets with different costs, regulations, and liquidity.
- Short-term alpha. For active managers, a high rate of alpha decay requires a more urgent trade strategy.
- Price volatility. High price volatility implies high execution risk, defined as the risk that an adverse price movement will occur over the trading horizon.
- Security liquidity. Greater liquidity decreases execution risk and market impact cost.
- Market conditions. Key market conditions that affect trading cost are volatility and liquidity levels.
Individual risk aversion. A portfolio manager/trader with higher risk aversion is typically more concerned about the market risk of adverse movements in security prices than market impact costs and therefore will trade with more urgency.
Market impact comes from trading too quickly, causing adverse price movements and information leakage as the market notices the liquidity imbalance in the market.
On the flip side, execution risk, the risk of adverse price movements over the trading horizon, is caused by trading too slowly.
Therein lies the trader’s dilemma—alleviating market impact causes execution risk, and vice versa.
The trading strategy selected by the manager and trader should reflect the costs and risks discussed in the previous section and be consistent with the manager’s objectives. Examples of some common trade types and their most appropriate trading strategy are shown here:
|Short-term alpha||Objective: Trade short-term mispricing in a liquid equity market (e.g., overreaction to news flow).|
Reference prices: Price target benchmark linked to the manager’s estimate of fair value combined with an arrival price benchmark for orders when placed in the market
Execution method: Computer algorithm (discussed later)
|Long-term alpha||Objective: Trade over the long term due to changes in fundamental conditions (e.g., sell average-sized positions in illiquid bonds that are expected to experience deteriorating credit conditions over the next year).|
Reference prices: Difficult to use in practice
Execution method: Sell securities gradually over a few weeks in small parts to avoid information leakage and pressure on dealer’s prices.
|Risk rebalance||Objective: Rebalance or hedge risk exposure.|
Urgency: It is low, since the trader is both buying and selling, which lowers execution risk. Execution risk would be higher for trades on only one side of the book since then the trader has directional exposure.
Reference prices: TWAP
Execution method: Algorithmically target TWAP over the next couple of days.
|Cash flow driven(client redemption)||Objective: Liquidate the holding to meet client redemptions. The fund bears the risk that liquidations are not made at the closing prices used to calculate the redemption.|
Urgency: The trade needs to be completed by the end of the trading day.
Reference prices: Closing price
Execution method: Execute a reasonable amount of liquidity in the closing auction; execute the remainder before the close of trading (e.g., at VWAP).
|Cash flow driven(new trade mandate)||Objective: Invest new client funds. Performance measurement will begin at the current day’s closing price.|
Urgency: Liquidity is too low to execute in underlying securities by the end of the day, but immediate exposure is required by the client. Liquid index futures contracts exist.
Reference prices: Closing price
Execution method: Obtain immediate exposure to index through a long position in index futures to eliminate cash drag. Build underlying stock positions over time to reduce market impact, while simultaneously unwinding the futures position.
Benchmarks for Trade Execution
Reference prices are used to determine expected trading costs, which enables managers/traders to select the optimal strategy for a trade. Reference prices are also a key input in the calculation of the actual cost of trading for posttrade evaluation.
Reference prices can be categorized as pretrade, intraday, posttrade, or price target.
Pretrade benchmarks are known before the start of trading. These include:
- Decision price. This is the price at the time the portfolio manager made the investment decision.
- Previous close. This is the closing price on the previous day.
- Opening price. This is the opening price on the day (often used as a proxy for decision price for subjective fundamental managers investing in securities for a long-term alpha, since it does not punish or reward traders for news released overnight when markets were closed). Note that if a trade is to be entered into an opening auction, which sets the day’s opening price of a security at a trading venue, then this opening auction price is not a good benchmark since it can be affected by the trade.
- Arrival price. This is the price of the security when the order is sent to the market for execution. Active portfolio managers trying to generate alpha will often specify a benchmark for an arrival price.
Intraday benchmarks are based on prices during the trading period. These are used by managers who trade passively over a day or funds that may be rebalancing or minimizing risk. Intraday benchmarks include:
- Volume-weighted average price (VWAP). This is defined as the average price of all trades, weighted by volume, over the trading horizon. Managers may use the VWAP benchmark when they want to participate with volume patterns over a day. Managers specify VWAP to help achieve the objective of using the cash received from sell orders to fund buy orders of the rebalancing.
- Time-weighted average price (TWAP). This is the equal-weighted average price of all trades executed over the trading horizon. TWAP may be appropriate for managers who wish to remove the impact of outliers since they believe they are less able to participate in these extreme trades. It is also appropriate in market environments with highly fluctuating volume throughout the day.
Posttrade benchmarks are determined after trading has been completed. The most frequently used posttrade benchmark is the closing price, often used by managers who wish to execute at the closing price to reduce the tracking error of the fund. A drawback of this benchmark is that since the closing price is not known until after the trading is completed, a manager cannot assess trading performance during the trading horizon.
Price target benchmarks are prices used by profit-seeking managers aiming to earn short-term alpha, related to the manager’s view of the fair value of the security.