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.