Buy-side use of algorithms is projected to climb next year as firms increasingly opt for self-directed trading as a way to cut costs, according to a new report by Tabb Group.
During the financial crisis, buy-side firms were more apt to deploy sales traders rather than algorithms in hopes of getting accurate color and guidance as a way to navigate the extreme volatility clouding the market. But in a stark reversal, 35 percent of buy-side firms are expected to use algorithms in 2011, putting them on par with high-touch sales-traders for the first time, the report says.
And although sales trading remains the dominant source of commission revenues, Tabb predicts that algorithms will continue to gain ground.
“Overall the comfortability of the buy-side trader has grown over the years in self-directing their trades,” says Tabb Group analyst Cheyenne Morgan, who co-authored the report with Tabb Group’s director of research, Adam Sussman. “And so in terms of cost, it’s much cheaper to use low-touch tools than to go to a sales trader.”
Morgan adds that although the buy-side largely turned to sales traders during the height of the financial crisis, they also used algorithms to a lesser extent during that period. That experience left buy-side firms better equipped to handle their own trading in the wake of a volatile market.
The report, entitled “U.S. Equity Trading 2010: Low-Touch Trends,” also says that algorithms are the clear winner among the different trading tactics being employed on the buy-side. As a result, competition among algorithm providers has been fierce.
“It’s becoming intense because algorithms at one point did become commoditized,” Morgan says. “They all pretty much did the same things. What’s going to determine who maintains the lead is … who comes out with the most innovation. The next step in that direction is going to be customization for algorithms and basically the ability for the buy-side to incorporate all of their strategies into each algorithm.”
The research, which was based on interviews with 123 head traders at U.S.-based institutional equity management firms, found that Credit Suisse was the most popular algorithm provider for asset managers and hedge funds. Investment Technology Group, Bank of America Merrill Lynch, Goldman Sachs, and UBS rounded out the top five, respectively, according to the report.
Algorithms are also growing in popularity on the buy-side because they allow a smaller number of traders to handle a larger volume of aggregate order flow than would be possible if trades were executed manually, the report adds.
While performance remains the most critical factor when determining an algorithm provider, among asset managers and hedge funds, there are some slight differences in what they each look for, the report says.
Hedge funds prefer algorithms that can determine when a venue is optimal, stay there and access as much liquidity as possible. And since hedge funds tend to trade more, they are more focused on accessing a broad range of liquidity.
As for asset managers, the report says they’re more likely to deploy algorithms for a range of fund strategies and order objectives. They might also want to dictate the configuration of routing criteria.