Customised algorithms
The world of algorithms (algos) has been a key part of the electronic trading landscape for many years. Now though, the way the buy side uses algos is changing, once again driven partly by regulation. MiFID II places a greater obligation on the buy side than ever before to understand the algorithms it is using and how they work, and to be able to explain this to the regulator on demand. 
Arising partly out of incidents such as the Flash Crash of May 2010, when $1 trillion was briefly wiped off the value of the US stock market by algorithms feeding off each other in a spiral to the bottom, MiFID II demands a new approach to algorithms. Many buy side firms report that they are cutting the number of algos they use, and paring down the amount of different customisations. The reason given by many is that the regulation suddenly makes having a large number of different algos a risky proposition, since any firm that finds itself unable to explain exactly how each one works faces punishment from the regulator.

 
“We see two competing forces,” said Hilton. “One is a focus on decreasing complexity from the buy side. They feel they have a greater regulatory obligation to understand what the tools do, so want to simplify the strategies they have access to. On the other hand, there’s a huge focus on performance and TCA. The buy side want to get into the guts of performance and understand what they can do to improve things. There’s more focus on tweaking things to improve outcomes by a small degree. For example, figuring out a more intelligent minimum when trading in the dark, or modifying the VWAP curve because the trader has momentum in the names they are trading, or maybe just a small tweak that makes better use of the closing auction. These are the kinds of changes that are popular.” 

The other factor, said Cousens, is a better in-depth understanding on the buy side in terms of what drives alpha for their flow. This greater awareness feeds back into the trend already noted above, since it leads the buy side to consolidate its algo providers and the number of algos that it uses. Credit Suisse notes that most buy-side clients are using two customised algos, on top of a selection of headline strategies.
As with many aspects of the market today, data lies at the heart of the issue – and there are a number of issues to tackle. Hilton notes that trying to compare performance across different data sets, whether that be two strategies, or two brokers, is not easy. The data needs to be as similar as possible for any conclusions to be meaningful, but this is not always a simple task. It’s necessary to consider whether the data has been impacted by events in the market (such an election), or that the data is simply not homogenous, which would make broad comparisons flawed. The best way to analyse data may be to test different trading scenarios side by side, for example by running an order to strategy A and then running it to strategy B in a randomised way over a period of time, to see which produces better results.

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The shift to the close
The profile of the trading day is changing. A number of market participants have observed in conversation with K&KGC that there is a shift of trading activity towards the close, with liquidity thinning out in the intra-day trading sessions. The scarcity of intra-day liquidity led one buy-side trader to ask, half-jokingly but not entirely without serious intent, whether traders should just start trading at 4.30pm and trade the close. Credit Suisse estimates that intra-day depth of order book has been at its lowest level in the last four years. However, one possible criticism of the close is that since it is still based on the national exchanges, it is quite monopolistic – a situation that plays into the hands of exchanges, which can then charge higher costs. 

“There has been a growth of the closing auction,” said Hilton. “That goes hand in hand with investment in passive products. Active fund managers are struggling to beat bench marks. Passive fund managers have done well. They often have the close as their benchmark. On the FTSE 100, 18% of daily volume goes in the closing auction. It’s a huge event and on rebalance day it can be as high as 40%. Even if you’re not focused on the close, you need to take account of it.”

From a Credit Suisse perspective, one area of focus has been predictive analytics. As Cousens points out, if the close has become more important than the ability to predict what liquidity will be present in the close becomes more important. If a trader can predict that, then the trader can figure out what they should trade earlier in the day. Credit Suisse has been researching this area, and has created a quant model that produces predictions. It looks at factors such as volume and volatility. A new model introduced in the last six months has significantly improved error-rate of the predictions the bank is making, he says.  This becomes important, because a more accurate prediction helps the buy side to trade during the close. 

“The close is hugely important,” added Cousens. “It has grown so much to the point where it is a standout liquidity event that attracts liquidity from all types of houses. As a result, the active managers are now looking at the close in closer detail, because there is so much liquidity available at that one point in time.”

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ETFs and passive style
The other major factor at work in today’s equity market is the shift towards passive investing and the related growth of ETFs. This trend owes much to the increased correlation in the market between different asset classes, which has been partly driven by central bank policy since 2008. In general, the value of assets under management in passive funds has been increasing significantly in recent years, with many funds switching from active management to passive management. 
According to Hilton, the main driver is performance versus cost. In the current environment, cost has been a problem for the active asset manager. This is particularly severe given that it is difficult to provide outperformance in equities today, which then makes it very challenging to compete with passive products that run at a fraction of the cost. 

“A number of traditionally active managers are looking to launch passive funds,” he said. “Passive is increasingly becoming a part of the active landscape too. The question is, can the active asset manager make better use of passive products to diversify their business.” 

Credit Suisse has been educating clients on the impact of passive trading. In general, the firm notes that the ETF market is seen as a useful way to trade macro events such as Brexit, the US election in November, and other significant events, including the upcoming elections in several European states. However, it is worth noting that regulation is pushing ETFs towards a similar environment to single stocks. 

“We see an increased appetite from the buy side to interact with different ETF providers,” said Cousens. “There’s a potential for a big change in how ETFs trade. In the US, ETFs are very liquid. In Europe, it’s still largely OTC driven. We are also investing in ETF products, which will help bring liquidity together for the buy side.”

Different buy side traders have differing views on the trend towards passive investing. At the recent K&KGC 14th Alpha Trader Forum equities in London, one trader highlighted as his priority how to stop the trend. However, at the same meeting another trader stated that his objective is the opposite; not to stop the trend, but how to benefit from it. So could the trend to passive reverse at some point, particularly given the impact of major macro-shifts such as the election of Donald Trump in the US and his statements concerning deregulation of US banks? 

“Passive trading and high correlation in the market are linked,” said Hilton. “If that link were to break down for any reason, the market could move back towards active trading. It was the high correlation that made it more difficult to generate performance in active trading. The election results will clearly impact the opportunities that exist. Some sectors will do well, and others… we will see.”