From: Jeff Danoff
Sent: Tue 8/2/2005 9:30 AM
To: Earl Spencer
Subject: -- =DJ 'Trading Algorithms' No Longer Just
Jargon On Wall Street --
-- =DJ 'Trading Algorithms' No Longer Just Jargon On Wall Street
By Mohammed Hadi
Of DOW JONES
NEW YORK (Dow Jones)--Trading algorithms, long
the domain of brokerage firms,
are coming soon to a money manager near you.
Not to be confused with trading models, which help managers
identify what to
trade, trading algorithms are software programs that mimic
human traders by
taking orders and executing them according to a managers'
These programs aim to improve execution by taking into
account the most minute
changes in the market, breaking trades into tiny
pieces and seeking out
liquidity wherever it exists on the open market, all
at a much faster speed than
a human trader and with relative anonymity.
Trading algorithms programs aren't new. Brokerage firms have been
for several years on behalf of their clients. But now, the
software is being
redesigned and repackaged for fund managers or their
traders. One expert
compared the new version to travel Web sites. They are
still powered by the same
kind of technology, but with an interface that
practically anyone can use.
Large brokerages like Bank of America
Securities and Lehman Brothers have
established what are essentially
in-house software development firms that
produce the repackaged algorithms.
Meanwhile, others like Algorithm Trading
Solutions, a boutique firm formed
about a year ago solely to develop algorithms
for fund managers, are
offering up some competition.
Still, when it comes money managers
directly using these programs, it's early
going and fund managers who do
use the software say that it isn't foolproof. It
requires oversight and, if
improperly used, can end up costing a fund more in
poor execution than it
saves in low commissions.
Putnam Investments, the mutual-fund giant
that manages about $200 billion in
assets, has used algorithms for about
two years, said Rich Block, director of
Global Equity Trading. The
software, "allows us to maximize the effectiveness of
trading a liquid
order, at a lower commission rate, and at excellent execution
have the trader spend a greater percentage of his time working harder
trade names," he explained.
However, for Block, it's really all
about saving money; with that in mind, the
software is most effective when
used to trade liquid stocks. On such trades, "a
sales trader won't be able
to add significant value," so Putnam's traders will
use an algorithm.
Putnam currently uses the software for about 10% to 15% of its
As for the broader asset management community, "basically we are in
adoption and experimentation phase," said Rob Flatley, managing
director at Banc
of America Securities' electronic trading services group.
Flatley estimates that
only about 5% of trades placed by money managers are
executed on the new
But, "we expect a
doubling of order flow each year into these tools over the
years," so that by 2007, 20% of hedge fund and mutual fund trading
conducted using an in-house algorithm, he added.
managing director of execution services analytics at Lehman
thinks one growth driver is the rapid increase of hedge funds. He said
software appeals to this group because it can handle the mundane
allowing a funds trader to focus on more difficult stocks, and it
degree of anonymity because by breaking the order up into tiny
pieces, it keeps
the market from sensing that a large order is brewing.
Also, "if you are a hedge-fund manager and you are gathering assets
speed, you could basically grow five times and not have to hire
Banc of America's Flatley said.
As far as costs
go, Banc of America charges about one-and-a-half to two cents
a share for
trades placed through its algorithms, depending on various factors,
said. That's below the three cents typically charged for a human
This means the big brokerages are likely eating into
their own trading
commissions by offering trading algorithms directly to
fund managers. But they
don't have a choice, because competition for
trading algorithms is getting
intense. "I think it's pretty clear that this
was going to grow with or without
us," said Cushing.
partly because the big brokers aren't the only ones offering the
to fund managers. George Rodriguez is a managing director at
Trading Solutions and is a trading algorithm bull. He thinks the
will become the primary form of stock trading among institutions,
he does note that traders can't be replaced completely. His firm
offers algorithmic trading services to clients, although it can "fill
blanks" when an order cannot be completed by the software.
There is evidence of the increasing use of algorithms.
For example, trading algorithms increase message traffic on the exchanges
they adjust and readjust orders. According to one measure provided by
message traffic has doubled since about a year ago and is up more
fold since the beginning of 2004, which the exchange said is a
sign of the
increased use of algorithms.
Plus, trade sizes are
getting smaller and smaller, which is a mark of the
trading algorithms. For
example, average execution size for algorithmically
placed trades at Banc
of America is down to 180 shares, Flatley said. That's
from orders of
several thousand shares.
But Lehman's Cushing noted the drop in
trade sizes is both a reason for the
increased use of algorithms, as well
as a result of it. "The decreasing trade
size was primarily kicked off by
decimalization and algorithms evolved to fill
the need for trading in
Also, the software is likely one factor
contributing to the rise in program
trading. Already, "a significant
proportion of program trading, definitely a
non-trivial percentage gets
ultimately carried out via an algorithm," Cushing
trading already typically accounts for more than 50% of
trading on the New
York Stock Exchange, and that figure is bound to climb as
managers trade stocks in baskets, because trading algorithms allows
do so with greater ease. "A lot of the brokers that offer algorithms
are starting to offer algorithms for programs," Flatley said.
if the use of algorithms doesn't reach the proportions that
expects, increased use of the software is going to change a stock
in many transactions. Sales traders at brokerages "will
become more of a
consultant or a coach," Flatley said, advising clients on
how trades can be best
executed and which algorithm to use depending on
Still managers have much to consider when
deciding which algorithms to employ,
or whether to use them at all.
Analytic Investors, a manager of more than $7 billion in assets,
using algorithms for about three years. The firm only invests in
securities in developed markets, "which is particularly useful
for these types
of algorithms because that's their strength," said
portfolio manager Dennis
Analytic Investors' use of
algorithms highlights the highs and lows of the
tool. When Analytic
Investors first started using algorithms, it executed about
half of its
trades using this system. Today, algorithms account for less than
the firm's trades. Bein said the sharply pared-down usage reflects
firm's experience that, unsupervised, algorithms can increase execution
that outweigh saved commissions.
"We find them to be
valuable tools that, when used by a trader, provide
optimum levels of
execution. But when used blindly - as they were designed to be
function - they frequently make foolish decisions," he said.
is some common sense that needs to be used," of which the algorithms
incapable Bein added.
-By Mohammed Hadi, Dow Jones Newswires;
(END) Dow Jones Newswires
Copyright (c) 2005 Dow Jones & Company,
02-Aug-2005 14:29:39 GMT
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