Fund firms overlook the value-creating qualities of the trading desk

Originally appeared in the Financial Times

Imagine if asset management companies could bring on board an incremental alpha-generating team at no extra cost? And, no, I’m not talking about robots. 

I believe they can. Today there exists a largely untapped source of alpha that is largely overlooked — the trading desk. Why untapped? Buy-side traders currently spend the bulk of their time focusing on alpha preservation, often called “best execution”. Let’s be clear. Alpha preservation is an essential part of the investment equation but a trader’s best outcome is simply implementing the orders of a portfolio manager (PM) with as little cost as possible.

By contrast, alpha generation at the trader level — or trader alpha — adds to the overall performance of funds. This is not a substitute for traditional PM alpha but rather an incremental extra on a fund’s performance that can create a measurable difference. While a PM focuses on longer term strategies that constitute most of the funds’ returns, trader alpha is short-term and derived from trader insight. This will inform and, at times, alter the investment strategy.

Traders have a unique vantage point into micro-market activities; supplementing this knowledge with data and analytics can unleash untapped short-term alpha to investment managers.

We speak to traders worldwide about their roles and responsibilities and how these are perceived within their firms. We hear the same thing: a trader’s primary role is to achieve best execution, to find the liquidity to fill the orders created by PMs at the best price. Then we ask the same traders what their most valuable contribution to their firm could be. The answer often involves better integration with the investment process. The challenge is how to free up more of a trader’s time without jeopardizing best execution, to enable them to provide a shrewd view of the investment process.

With advances in technology, trading has become more self-directed and automated. These solutions use technology to understand the nuances of local markets, market microstructures, intraday trading patterns and market-moving information to arrange best execution. The answer is to apply these tools to the best execution process. Then instead of a trader spending the bulk of their time trying to achieve best execution for every order on the blotter, they could use intelligent, best-execution automation tools for a significant percentage of all orders.

This would free time to focus on outliers hit by unusual market and liquidity. This is trading by exception. Now the ratio is flipped: a trader only “trades” those names where there is potential for notable impact cost (or on the flip side, significant savings), and most of the time is spent delivering trader alpha.

Short-term alpha requires a unique focus. The opportunity is to provide the tools and the training the trading desk needs to create tens or hundreds of basis points of alpha. Trader alpha can be found by identifying unusual short-term stock moves or changes in liquidity imbalances. It means developing a short-term thesis backed by historical probability created by looking at leading indicators from option volumes, credit default swap spreads, short interest moves and insider selling.

Changes in market microstructure, trading patterns and money flows are fertile areas in which to find short-term alpha. For many companies such a shift in focus will be a challenge. Traders will have three requirements: the right automation to drive best execution; the data and the technology to provide the intelligence to create short-term alpha, and management support. Once all three are in place, the role of the trader becomes less about saving a few basis points on implementation and more providing the insight to give portfolio managers the potential to add hundreds of basis points to performance.

In this competitive world, no form of potential alpha generation should be overlooked. ♦

Seth Merrin, CEO and Founder