Transaction costs can significantly diminish the returns of even the best investments, prompting the emergence of a new breed of tools designed to reduce trading risks, according to fin
Transaction costs can significantly diminish the returns of even the best investments, prompting the emergence of a new breed of tools designed to reduce trading risks, according to financial consultancy firm Tabb Group.
‘Best execution needs to be looked at from the portfolio perspective to preserve projected portfolio returns,’ says Matt Simon, a research analyst at Tabb Group and author of the report Portfolio Decisions and Trading, Aligning Execution to Investment Needs. ‘From pre-trade analytics to alternative trading systems, there are a whole new host of trading technologies being developed that will help merge portfolio management and trading.’
If trading of buy orders and sell orders, collectively known as the basket, fails to stay ‘inline’ with the desired portfolio characteristics, claims Simon, funds are exposed to a number of unwanted risks.
He points out that the profile of a ‘typical’ basket, also known as programmes or lists, includes over 95 individual names and nearly USD110m in notional value, making them high-risk entities for any trading desk.
In a market where ten per cent intraday swings are now the norm, Simon says, even the briefest moment of excessive exposure to a particular factor, such as sector or style, can make or break a trade’s profitability.
‘It’s the goal of the trading desk to maintain alignment between the drivers of the investment decision and its implementation in the markets,’ he adds.
Current market volatility is causing brokers to limit levels that they can actually guarantee, increasing the relative percentage of agency trades and self-directed orders. In past years, principal risk bids have been a major part of how portfolio decisions were executed, but the evolution in electronic trading is now reframing how this is being done in the marketplace today.
‘Execution venues are creating a market structure designed to execute baskets inline with their desired exposure and risk characteristics,’ says Simon.
He believes the key is to balance the functionality that allows traders to maintain desired behaviours across a number of characteristics while attracting enough liquidity to meet the constraints of as many basket orders as possible. This can be achieved by adding the flexibility to focus on the characteristics of the basket instead of the actual constituents within the basket.