United They Stand?
Before the introduction of the order management system (OMS) as we know it today, and before "algorithm" was the most common word on the trader's tongue after "trade," a typical investment management firm's portfolio manager and trader lived in different worlds. The portfolio manager developed a long-term investment strategy and communicated a list of shares to buy or sell on a daily or sometimes less-frequent basis, and the trader executed that list. At the end of the day, the portfolio manager would walk over to the trading desk, or phone the trading desk from the golf course, and ask, "How did we do?"
Today, that genteel image has almost completely washed away; it is no more accurate a description of these positions than "typical" is of an investment management firm.
The availability of real-time information in trading systems has meant that, by and large, a portfolio manager is much more actively involved in the trading process and no longer has to ask anyone, "How are we doing?" because she knows, and it is her job to know. Also, a firm that is looking for a trader nowadays is much more likely to place "must know the ins and outs of algorithms, crossing networks and front-end trading systems" in the job description than "must be chummy with all the brokers on The Street."
The immediacy of knowledge facilitated by real-time information systems and algorithmic trading has made the relationship between portfolio manager and trader closer and, in some cases, the portfolio manager has taken on more of a direct role in trading. "About two years ago, I used to submit the trades to the blotter and forget about it," says Douglas Cote, a senior quantitative portfolio manager at ING Investments. "The new way is that the analysis of the implementation strategy and the analysis of pre- and post-trade information is now an integral part of the trade itself. The pre-trade analytics available to me now, versus two years ago, are very sophisticated. I know everything about the baskets before I send them to be executed."
Cote says that the advent of algorithms in some ways favors a portfolio manager's training over that of a trader. Algorithms take into account Modern Portfolio Theory, the methodology devised by Harry Markowitz in 1952, which emphasizes diversification across multiple sectors. It advocates that investors focus on selecting portfolios based on their overall risk-reward characteristics, instead of merely compiling portfolios from securities that individually have attractive risk-reward characteristics.
The typical trader's training considers only the immediate impact of the security price moving against him once the trade has been placed in the market: impact cost. But portfolio managers are trained to think in terms of long-term effects and the risk they may be taking on by acquiring securities with a potential to drop in value, or the opportunity cost of letting go of securities that have a relatively good chance of appreciating.
"Most traders consider just impact cost - is it high or low?" Cote says. "As soon as you introduce risk, that is the other part of the equation. It is not only about impact cost as in, 'What did it cost me to trade?' but as in, 'How much risk did I take on to do that?'"
Change Brings Adjustments
The beauty of algorithms is that they are constructed to consider both issues and readjust the trading strategy accordingly. And that is appealing to hands-on portfolio managers, because they can get more materially involved in day-to-day trade execution. This can be a new and intimidating phenomenon for traders.
"As a portfolio manager, I have very strong ideas on how things should be traded now and which algorithms I use, and it doesn't always go over smoothly. Change is never done without problems," Cote says. "Now, because of technology and the algorithmic capabilities, I can add value to the trading process to facilitate working with my head trader. Before, unless you traded every day, you didn't really get it."
However, Cote emphasizes, the idea of a portfolio manager replacing a trader, at least at a large firm, is far-fetched. But the availability of technology that was once only available to sell-side traders gives new meaning to the term "active management." "The same rigorous discipline we use for portfolio management will be applied to trading, but the trader will continue to be the point person for executing those trades," says Cote. "The best firm going forward will have a tightly integrated process for trading between the portfolio manager and the trader, to an extent not seen historically."
The combination of portfolio manager (PM) and trader has long been the case at Seattle-based Badgley Phelps and Bell, which trades about $1.5 billion in assets under management, about $500 million of which is in fixed income. The reason for this has to do with both the size of the firm - about 35 employees - and with the idiosyncrasies of the fixed-income market, which is less-automated and less-liquid than equities and requires more-active trading participation due to the vast variety of, and lack of, standardization in fixed-income securities, says Calvin Spranger, who is both a portfolio manager and trader in Badgley's fixed-income department.
"I am ultimately responsible to the client, so I want to have as big of an impact on the trading as I can," says Spranger. "I think it matters a little more for fixed income - you cannot just type in the symbol and pull up a quote. You have to talk to people to have a good feel for the market. The equity portfolio manager can spend a little more time just sitting in front of their quote screen."
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