Tools to reduce subjectivity in the selection of brokers and strategies yield new efficiencies and improve performance among asset managers, writes Allan Goldstein of Trade Informatics
It is said that there is more than one way to skin a cat, and in this era of heightened transparency and intense drive to achieve best execution, investment firms should bear this in mind.
From algo wheels and broker wheels to bracketing and scoring of algos and counterparties, there are multiple ways to implement effective execution strategies. Trading desks must work closely with their portfolio managers to choose the approach that works best for their own organisation, one that quantitatively ties an execution strategy to a defined portfolio segment.
This may be a new way of thinking for many firms. Portfolio management and trading have often been separate disciplines with a subjective intersection of interaction with the trader. The portfolio manager focuses on asset allocation and portfolio construction, while the trader sources liquidity for portfolio decisions. Those two mandates are still broadly the same today, but greater and measured collaboration is needed to implement effective execution strategies.
The most effective investment process brings traders into the portfolio construction process, so that portfolio implementation decisions are made with an understanding of alpha characteristics. In this way, key execution issues are considered at the outset rather than being left until later, and traders can feed their knowledge and expertise into the portfolio management process.
Some firms have taken this a step further by using broker wheels or bracketing frameworks to systematically organise the process of counterparty and algo selection. Bracketing, for example, allows firms to set certain key characteristics for the type of strategy they might use, such as the level of aggression in an algo and the extent to which it will impact the market. Algos are then grouped into those brackets to make the selection more straightforward and less subjective.
Janus Henderson Investors, a pioneer in this field, introduced a bracketing system in 2009 and has since reduced the number of algos it uses from 250 to less than 45. It now operates a sophisticated system of seven distinct brackets and has further honed its approach over time.
Meanwhile broker wheels and algo wheels are an increasingly popular way of removing subjectivity from the selection process and leading buy-side firms to the counterparty or strategy that best suits their pre-defined execution criteria. Such wheels will randomise the brokers and algos that meet those criteria so that the selection should be more objective and transparent. Broker scorecards also help to systematise the monitoring of counterparty performance and hold brokers to account on the quality of their service.
These new approaches to order execution are not only about realising greater efficiency, transparency and accountability. They also have the potential to improve investment performance, preserve alpha for the end investor and avoid costs often incurred when orders pass through multiple internal and external investment agents prior to execution.
This is still a work in progress for many institutions, but with a more explicit regulatory requirement to take all sufficient steps to achieve best execution, we are confident that customization of an implementation strategy by tying it to an order source is an exercise of increasing interest and is proving to yield tangible results for investors.
To find out more, read our latest article on the topic here.