Best Execution

Lightening the hedge fund trading footprint

Originally published in the October 2007 issue

For partners in a hedge fund, forgoing revenue with a soft close is a big decision. Lack of investable ideas might be a major influence, but a heavy trading footprint is another. Tools that lighten that footprint are very valuable.

Efficient trading is important at all levels. For instance, hedge funds which run managed accounts alongside their main fund will undertake frequent rebalancing trades for cash flow reasons. Often today such trades are executed via the prime broker for ‘ease of administration’ reasons. Being considered simple executions and/or crosses, they are thought ‘only’ to need trading at mid, open or closing prices. It is not clear that this is an acceptable, let alone best, practice. At the very least a tool is needed to improve productivity.

The fiduciary duty on a fund manager has always existed. However with hedge funds inexorably moving into the institutional arena and the attendant higher profile on the regulatory radar screen, there is greater need for demonstrable evidence of best practice. MiFID might very well be over-engineered and oft criticised but can any manager really doubt that more focus will fall on Best Execution.

Understanding the tools of the trade

It can be argued that the regulatory bite of Best Execution and the strength of clients’ interest in it has to date been weak. MiFID will surely strengthen the former. But the reality of the latter is that in all businesses clients matter and hedge fund clients will continue to become better informed on trading.

Thus whether or not MiFID will have regulatory teeth, it is likely that hedge fund managers will need to look further at their trading process. Dealing with just the prime broker and a small number of other counterparties will not be adequate. A tool to facilitate trading by obtaining real quotes efficiently will be required. This tool will need to be able to automatically record the process for good internal management control. But at the same time external audit and internal compliance will demandsuch records.

Clients are more aware now. They have used eBay. They understand that greater value can be received by displaying their wares to different constituencies. They might not use the jargon, but they understand the concept of price discovery.

Many new trading venues have already appeared and many are in gestation. From 1 November MiFID will exacerbate the already real share price discovery problem. Liquidity will no longer be forced to concentrate at one venue through old regulatory or protective diktat. Thus the old status quo will be further upset. For example, what will be the end of day share price? And will ‘piggy back’ pricing on the back of one exchange quote still be possible for the crossing networks? Turning to the program trading market, this is huge. It encompasses not just the big 100 plus share portfolio lists, but also a fund simply switching, say, 3 or 4 retail stocks into 2 or 3 technology stocks. Surveys indicate one third of all share trading worldwide, perhaps US$14 trillion or so, is via programs. Yet program trading for almost all managers is a manual and clunky business.

Power to the managers

Some doomsayers have actually said that program trading will die and algorithmic trading will replace it all. Let us not discuss that in depth here other than to say a tool that enables the hedge fund manager to take control of its program trade process quickly and cleanly puts power in the hands of the manager. This is where power should reside. The manager is exactly that, the fiduciary manager of client money, not a broker. Liquidity resides with the manager, not the exchanges and the brokers. The manager though needs a good tool. Whilst many broker tools are good, they are not purposely designed for the buyside, either in form or in commercial intent.

Some have also argued (not just the brokers) that program trading is cheap enough already; “Why bother to save the odd basis point?” Abstracting from the obvious performance point, the fiduciary duty to manage client money – other people’s money – properly can never be taken lightly. One basis point on a not atypical £100 million trade is £10,000. The trustees of pension funds will know better than most that the average pensioner does not take home £10,000 per annum. Perhaps they might also consider such an, almost cavalier, attitude as an indicator of whether a manager is the right choice to manage their assets.

However, on the positive side, those trustees will be impressed if they see that the hedge fund manager is proactively addressing trading issues. MiFID will stiffen the need for demonstrable evidence of a comprehensive, electronic and auditable Best Execution process. Such evidence is also a great opportunity to further exhibit to clients the hedge fund’s competitive advantage.

A good tool is needed to facilitate the management of large and small program trade auctions with many different brokers at the same time. It will allow the hedge fund manager to easily analyse what has worked well in past trading and what can be improved upon. A database brings objectivity to the task of lessening the dealing footprint. The tool will allow easy access to more specialist or regional brokers and more bulge bracket brokers who can add value. If they do not add value they should not be used but the best should be sought out. That it is administratively difficult to ask more than the same two or three brokers is damaging to performance. It is also entirely unacceptable if Best Execution is to mean anything.

A good tool allows the hedge fund manager to create an auction in those circumstances where an auction works best – where the value of a unique item is uncertain. A program composed of even a few stocks is a unique package. The price of that package will change as fast as market conditions and the brokers’ inventory. A tool is needed that can create, control and conclude auctions quickly.

Clients know eBay discovers prices – real prices that a buyer will pay. A seller does not need to put an item into a pre trade Transaction Cost Analysis model to determine its value first. Need one do so with a unique program trade when the right tool can discover what value added brokers will actually pay for it there and then?

eBay also shows there are new and extendible methods of trading that benefit both buyers and sellers. If a program makes sense why not choose a competing bid auction rather than the present sealed bid process? Why not choose to show summary details of the program to the market in addition to those brokers you always go to? One broker not invited might have an axe in the stocks. Let that broker ask you if it can bid – you should have the power to accept or refuse. Or why not ask for a bid on an anonymous basis? Does disclosing your identity always work in your favour? Or perhaps more pertinently, can you convince your client it is working in its favour when he hears “my broker always gives me the best price” from you and all its other managers?

Keeping up with innovation

Hedge funds are innovative. The trading tools available to them must facilitate that innovation. The tools must be instantly available. This is why web-based tools only requiring a user name and password are attractive. They do not require a long, messy and expensive IT install. The tool should be user friendly and simple to integrate with a full blown Order or Execution Management System. But importantly it should work just as easily with an Excel spreadsheet or even allow the hedge fund to create a program trade directly. It is appealing if that tool is very low cost too.

A great deal of hot air has been generated over MiFID and Best Execution. However clients are fast realising that it is not difficult to assess whether an investment manager is properly and reasonably transacting on their behalf.