After a major crisis, it's only natural to pause and take stock of the situation. With the collapse of big sell-side names and shotgun marriage-style mergers, hedge funds and other buy-side firms are surveying the new financial landscape and making some very important decisions. If they want to survive, the buy side must take appropriate action now.
This past May and June, Advanced Trading asked some of our readers to participate -- anonymously, of course -- in a concise and focused survey of their trading practices, IT strategies and preparation for sweeping regulatory reforms, including the Dodd-Frank Act. The responses were illuminating.
According to participants, while the industry is keen to adopt new technologies and advances, most firms take a cautious approach when using them on a day-to-day basis. And while social media is taking the world by storm, the secretive buy side -- known for keeping its cards close to its vest -- isn't taking to Facebook like the average teenager.
OK, full disclosure: We received 34 responses to our online survey. But financial services firms are notoriously tight-lipped when discussing, well, anything, and the buy side is even more secretive. So while the survey's sample size is not large enough to render the results statistically significant, the insight from the survey certainly is.
Who Are You?
With this in mind, let's find out who responded. Ten participants indicated they were hedge funds or buy-side firms with $10 billion to $100 billion in assets under management (30.3 percent); nine (27.3 percent) said they had $100 million to $1 billion in assets, and another nine said they had $1 billion to $5 billion in AUM.
When it comes to the size of the firms, 57.6 percent said they have between one and five traders, while 24.2 percent responded that they have six to 10 traders on staff. Three firms said they have 11 to 25 traders, and three said they have more than 25 traders.
"Most hedge funds that have less than $1 billion make up a big part of the community," says Matt Samelson, principal at Woodbine Associates, a market research firm that covers the hedge fund industry, reflecting on our informal findings. "I bet you have three to five traders at most of these firms."
What and Where Do You Trade?
Asked, "What asset classes do you trade?" 95.2 percent of participants said equities. Fixed income was a distant second, at 57.1 percent, followed closely by options and foreign exchange (47.6 percent each) and derivatives (42.9 percent); commodities were cited by only 23.8 percent. (As many hedge funds trade in multiple asset classes, multiple responses were allowed.)
Though a number of the participants declined to respond to questions about where they trade, the responses we did receive were particularly revealing. When it comes to exchanges outside of the United States, 54 percent, or 12 of the 22 respondents to the question, said they trade on the London Stock Exchange and 12 cited the Toronto Exchange (Canada TSX). A little less than half of the respondents said they do not trade on any exchanges outside of the United States.
The picture of dark pools was more clear: a solid 91 percent of the 20 respondents to the question said they do trade in dark pools. LiquidNet was by far the most popular dark pool, cited by 85 percent of the respondents, followed by Investment Technology Group (ITG), with 70 percent, and BIDS Trading (55 percent).
Woodbine Associates' Samelson isn't surprised by the overwhelming use of dark pools. "It comes down to best execution, and if you have a block-size order that is larger than what can easily pass through the market -- anything larger than 500 shares -- it makes perfect sense to trust dark pools," he says. "There can be very real savings there."
With the electronification of the markets nearly ubiquitous, it is no surprise that a clear majority or respondents use algorithms to sniff out the best price and execute at just the right moment. Eight-one percent (17) of the participants who responded to the question indicated that they use algorithms to achieve alpha. But where do buy-side firms get their algos?
Fifty-seven percent of the 17 respondents to the question said they get their trading algorithms from a sell-side counterparty, such as a sell-side investment firm. Fifty-seven percent also said they get their algorithms from brokerage firms that provide the formulas in exchange for a fee that is tied to executing the trade at the brokerage. Interestingly, just four respondents (19 percent) reported that they write their own algorithms. Again, multiple responses were allowed.
Why don't buy-side firms hire their own quantitative mathematicians to write their own formulas? Too expensive, says Samelson. Hedge funds "don't want the overhead and the risk associated with the person who writes the formulas leaving," he says.
Nonetheless, hedge funds don't appreciate off-the-rack algo formulas, either -- 47.6 percent of respondents said they prefer custom algos; 38 percent said it wasn't necessary or desirable. But firms were only willing to go so far to pay for custom algos -- when it comes to different custom algos for various traders inside a single hedge fund, 70 percent of respondents said, no, thanks.
Bucking the HFT Trend?
In a bit of a surprise, high-frequency trading did not appear to be in huge demand among survey respondents. An overwhelming 90 percent said no, they do not trade via HFT. And yet, of those respondents who answered yes, a clear 60 percent said more than half of their trades were executed via HFT.
Why the discrepancy? Woodbine's Samelson believes it comes down to confusion over the term. "This shows how people haven't really nailed down a good definition of HFT," he insists. "If you consider HFT as rapid turnover of a large number of positions to capture small movements of the market, it doesn't surprise me that a lot of people do not participate in that. They only associate it with the big boys."
But Samelson believes that a number of respondents to the survey probably are conducting strategies that would fall under "low-latency trading." "People often have confusion about 'low latency' and 'high frequency' -- everybody wants low latency. You want to go in and seize liquidity and what you see out there," he says. "But I think people interpreted your question as, 'Do people sink money into technology for HFT on a daily basis to capture small aberrations of the market?' My guess is, no."
Where IT Comes From
The old maxim that buy-side firms -- especially smaller hedge funds -- get their trading and information technology from large sell-side firms in exchange for the chance to execute the buy-side firms' trades appears to be true. Thirty-five percent of the 20 respondents to the question said that more than 50 percent of their trading technology hails from the sell side; but 50 percent (10 respondents) said less than half of their IT comes from their sell-side counterparties.
In the age-old debate of Buy vs. Build, the buy side apparently finds a healthy mix. Not one respondent replied that the firm builds all of its own technology (though no one on the sell side builds all of its own technology either). Nearly 43 percent of respondents replied that they "mostly buy/build some" of their IT; 19 percent said they "mostly build, buy some" of their wares -- such as order management systems, trading and data analysis tools -- while 38.1 percent said they buy all of their trading technology.
Facebook, Twitter and now Google+ may be all the rage in the outside world, but it appears that the buy side is still determining social media's role in the global capital markets. Asked if their traders use social media to interact with clients, counterparties or other financial professionals, 76.2 percent of the respondents to the question said, "No." Of the three extroverted firms that said they do participate in social media, all said they use Twitter, two indicated they use Facebook and two said they used LinkedIn. No one indicated they use "Google Buzz," but the survey was conducted before the search giant revamped its social network under the "Google+" banner.
According to Samelson, few hedge funds are leveraging social media. "In terms of communicating about business, you see Twitter and LinkedIn as the primary means of business communications," he says. "Twitter is more oriented for snapshot messages, and Facebook is a personal, social thing."
Following the financial collapse in 2008, the U.S. Congress passed in summer 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act, which rewrites many of the rules governing investment firms, including hedge funds. While in the past hedge funds often operated under the radar and away from the bright lights of regulators, now many of these once anonymous firms will be compelled to register with the SEC and reveal the names of their managers and advisers.
We asked our survey participants if they were taking steps to prepare for the implementation of the Dodd-Frank Act. Fifty-five percent of the 20 respondents to the question answered, "Yes," while 10 percent said, "No." Twenty percent indicated that they would begin preparing for the reforms "soon".
"They are like kids who pray for a snow day on the night before their book report is due," says Woodbine's Samelson of the firms that have not begun to act. "Our sense -- and it's completely unscientific -- that we get from smaller firms is that they prefer not to do anything."
Meanwhile, when asked about the impact that Dodd-Frank will have on their firms, most respondents (15 of 19) somewhat surprisingly characterized the impact as "minor change," and one respondent said it would have "no impact." Only three respondents acknowledged that the legislation would result in "major change" at their firms.
Samelson says it all depends on the hedge fund's strategy. "If you're a smaller, equity-based fund and you're executing a pairs strategy, it's not going to impact you much at all," he says. But, "It will impact those involved in structured derivatives." Phil Albinus is the former editor-in-chief of Advanced Trading. He has nearly two decades of journalism experience and has been covering financial technology and regulation for nine years. Before joining Advanced Trading, he served as editor of Waters, a monthly trade journal ... View Full Bio