Reading 23 Flashcards
Alpha Decay
deterioration in alpha once an investment decision has been made. managers with higher rates of alpha decay need to trade in shorter time frames and hence have greater trade urgency managers with long term company fundamentals will have lower rates of alpha decay and therefore a lower trade urgency
cash drag
low levels of return of cash cause the fund to underperform the benchmark
equitization strategies
when to avoid cash drag, liquid securities such as ETFs or derivatives are used to gain market exposure while the investment in underlying securities occurs over time.
Market Impact Costs
adverse effect of the order on prices
execution risk
risk of adverse price movements over the trading horizon from moving too slowly
trader’s dilemma
alleviating market impact causes execution risk and vice versa
Decision price
price at the time when the portfolio manager made the decision
Ref price and execution method for: Short term alpha?
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; use computer algo for execution
Ref price and execution method for: long term alpha?
difficult to use reference prices
execution: sell securities gradually over a few weeks in small parts to avoid information leakage and pressure on dealer’s prices
Ref price and execution method for: risk rebalance?
Low urgency, 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 price: TWAP
Ref price and execution method for: redemptions and creations
reference: MOC
execution strategy for new trade mandate
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. 2 problems though:
1. there may not be a closing auction for the futures contract, in which case the futures trade would need to be done as close to the market close as possible.
2. the mandate must allow derivatives positions.
Principal trades (broker risk trades)
dealers or market makers assume all or some of the risk relating to executing the order, which is prices into the spread. Quote-driven, OTC or off-exchange markets are primarily principal trade markets. RFQ also.
Profit seeking algorithms
use real time market data to determine which securities to buy and sell and are employed by electronic market makers, quant funds and HFTs
execution algorithms
trade according to the rules specified by the manager to meet the objective
scheduled algorithms
POV, VWAP, TWAP
disadvantage of scheduled algorithm
force trades in times of low liquidity or trade too little in times of high liquidity
liquidity seeking algorithms
aka opportunistic algorithms - aim to take advantage of favorable liquidity conditions when offered by the market. eg for a buyer, the algo would wait until a large sell order enters the market. these orders use both lit and dark vanues.
when are liquidity-seeking algos best for?
larger orders in less liquid markets with higher urgency while trying to mitigate the market impact. they are also appropriate when a manager is concerned that displaying limit orders may lead to information leakage, or when liquidity is typically thin with sporadic episodes of high liquidity.
what are scheduled algos best for?
relatively small orders in liquid markets for managers with less urgency ie greater risk tolerance for longer execution periods and/or who are concerned with minimizing the market impact eg a risk rebalancing trade executed over a trading day.
what are arrival price algos best for?
small orders in liquid markets for managers who believe prices are likely to move against them during the trade horizon and therefore wish to trade more aggressively eg profit seeking manager. they are also appropriate for more risk-averse managers who want to minimize execution risk
whom are dark strategies/ liquidity aggregators best for?
large orders in illiquid markets and arrival price or scheduled algorithms would likely lead to high market impact. since there is a lower chance of execution in dark pools, these strategies are for managers that do not need to execute the full order immediately.
what are SORs best for?
small orders with low market impact where the market can move quickly or for small limit orders with low information leakage where there are multiple potential execution venues.
Clustering
machine learning technique whereby a computer learns to identify which algorithm is optimal for different types of trades based on the key features of trades. the term clustering refers to the technique of grouping trades together with similar attributes eg size as a fraction of ADV.
best execution strategy for fixed income
high touch brokered approach since fixed income markets outside of treasuries and corporate bonds typically use high touch brokered execution methods. there is unlikely to be an algorithmic or DMA available for agency MBS.
if a large equity trade is not urgent, you should use?
scheduled algorithm
Implementation shortfall
Paper return - actual return
paper return: return on hypothetical portfolio if the trade were executed at the original decision price with zero cost.
actual portfolio return: net of all costs
usually expressed as basis points of the total cost of the paper portfolio
execution cost:
occurs due to executing shares a ta less favorable price than the original decision price. can be further broken down into delay cost and trading cost
trading cost
cost due to market impact of executing the trade
opportunity cost
cost of not trading any unfilled part of the order. paper portfolio assumes that all shares are executed immediately at the original decision price - the actual trade may have only filled part of the order, and the lost profit on the unfilled portion is the opportunity cost.
absolute cost of trading
side * (execution price - benchmark prices) * shares executed
side = +1 for buy order and -1 for sell order
trade cost (in bps)
side * [(execution price - benchmark price) / benchmark price ] * 10,000
index cost
cost due to general market index movements
index cost (bps) = side * [(index vwap - index arrival price)/ index arrival price] * 10,000
market adjusted cost
ensures a trader is not penalized or rewarded for general market movements over the trade horizon by subtracting the index costs adjusted for the security’s beta
market adjusted cost (bps) = arrival cost (bps) - Beta * index cost (bps)
arrival cost - arrival cost of the trade based on an arrival price benchmark
beta - beta of security versus index used to calculate index cost
added value (bps)
arrival cost (bps) - estimated pre-trade cost (bps)
negative cost means benefit and the trader has added value through trading decisions.
key areas of trade policy
- meaning of best execution
- factors tat determine the optimal trading approach
- a listing of approved brokers and execution venues
- details of the monitoring processes used by the asset manager
a PM who wishes to execute a trade passively over a trading day and mitigate the impact of outliers should use which of the following reference prices as benchmark?
TWAP
RFQ are most likely to be used to implement trading strategies in which of the following markets?
Fixed Income
Price benchmark where reference price for benchmark ignores outliers
TWAP
If a PM has inflow in a rising market, how can they avoid cash drag or minimize it?
To minimize cash drag on a portfolio, or fund underperformance from holding uninvested cash in a rising market, Barker may use a strategy known as equitization. In this case, equitization refers to temporarily investing cash using futures or ETFs to gain the desired equity exposure before investing in the underlying securities longer term. Equitization may be required if large inflows into a portfolio are hindered by lack of liquidity in the underlying securities. So, if the Pengwyn Fund’s large inflow cannot be invested immediately, Barker can equitize the cash using equity futures or ETFs and then gradually trade into the underlying positions and trade out of the futures/ETF position.
What is delay cost
Qty done * (decision price - arrival price)
Market Adjusted cost
arrival cost - (Beta * index cost)
arrival cost
= (value done - value at arrival for same qty)/ value at arrival for same qty
index cost
(index vwap - index arrival)/ index arrival
sell order for small position in a lightly traded name - no expectations of adverse price movement and wants to minimize market impact, but also complete the order. which algo should he use?
TWAP because VWAP might not complete
Which is incorrect?
Theme 1: We should determine an optimal execution approach and apply that approach to each asset class managed.
Theme 2: In aggregating trades for pooled accounts, any partially executed orders need to be allocated on a pro-rata basis.
Theme 3: The principles behind our process to find a broker should be consistent across each asset class managed.
Theme 4: To act in our clients’ best interests, we need to disclose all trade errors to them.
Theme 1 is inappropriate because the optimal execution approach may differ by asset class, level of security liquidity, and security trading mechanism (order-driven markets, quote-driven markets, and brokered markets). Green Savannah’s trade policy document should describe the factors used in determining how an order can be executed in an optimal manner for a given scenario.
Theme 4 is inappropriate because as part of a suitable policy for the treatment of trade errors, those errors and any resulting gains/losses need to be disclosed to Green Savannah’s compliance department and documented in a trade error log. The priority is to ensure errors are resolved in a way that prevents adverse impact for the client, not to ensure complete disclosure.
