Despite access to an ever-growing menu of electronic trading toys with greater sophistication, some money managers are finding that there is still room in their repertoire for the tried and true of block trading: capital commitment.
In fact, among the biggest clients on the Street, their usage of capital trades rose 11 percent in 2009, according to a recently released Greenwich Associates report. This tier-one group of clients–greater than $50 million in annual commissions–traded 29 percent of their dollar volume with broker capital.
Brokers report that the death of capital commitment has been greatly exaggerated. That’s not only true for Greenwich’s top tier, but also the next group, which pays $20-to-$50 million a year in commissions. This group saw a 20 percent rise in its capital trades, to 12 percent from 10 percent, Greenwich reported. Still, many traditional long-onlys say they have been weaned off capital as electronic trading tools have supplanted much of their interaction with sales traders and their high-touch services.
But whether you work at a hedge fund or a traditional long-only fund, there is one axiom that remains a constant: There is only one means to a block trade when no natural liquidity exists, and that’s by hitting up a broker for capital.
"The sellside is the only venue that can instantaneously manufacture liquidity," said Armando Diaz, who heads franchise trading at Citi. The percentage of risk trades at Citi, according to Diaz, is up by 50 percent from nine months ago.
Traders credit the uptick in capital commitment to a decrease in volatility and competition among brokers. However, client demand has been the key driver, as aggressive managers have looked to pick stocks that are breaking from the pack and they need capital to get there fast.
Traders say that capital trades plummeted during the heart of the financial crisis for two reasons: 1) Volatility was so wild, that both investors and brokers had no idea where to price orders; and, 2) Even if a broker and client could agree on a price, the risk premiums would have been astronomical, so clients opted for self-trading and high-touch help from sales traders–they averaged into their price, rather than making a big bet.
"Stocks were getting so whipped around, it didn’t serve the buyside well to ask for capital," said Scott Bacigalupo, who heads U.S. sector trading at Bank of America Merrill Lynch. "It became very expensive for them to access capital because the markets had to widen out."
But things are better now. Both brokers and money managers report that capital usage has regained the ground it lost during the financial crisis.
"It’s an uptick from 12 months ago and probably status quo with where things were two or even three years ago," said James Malles, head of U.S. equity trading at UBS Global Asset Management in Chicago.
Malles said there are about a dozen firms that he can ring to get good size done. That list includes regional brokers, too, who will stand up in the stocks that they traffic in. A regional might "sell you a hundred up a couple of cents and that might be as good as the larger firms," Malles said.
Henry Mulholland, who heads Americas trading and sales trading for Bank of America Merrill Lynch, agreed that capital has become more important to clients. The rise in capital usage began in the second half of last year and has "ticked up meaningfully in recent months," he said.
Volatility coming in has been one factor behind capital’s rise. Volatility, as measured by the Chicago Board Options Exchange’s Volatility Index–or VIX–has cooled tremendously since the crisis of 2008 and 2009. Generally, the markets are considered volatile when the VIX tops a measurement of 25. During the crisis, the VIX crossed 80, twice. And it hovered above 40 until early last April.
The VIX didn’t fall under 25 routinely until late-summer 2009. From late-February 2010 until late April, it ran consistently in the high-teens.
But no trend is perfect. Last month, volatility picked up during the Greek debt crisis and it averaged at 31 for a two-week period, from May 6 until Traders Magazine went to press. And once again, according to one knowledgeable trader, capital requests died down during the period.
Still, lower volatility is only part of the story for the upswing in capital-intensive trades. The other is how stocks are performing. Clients’ increased appetite for capital is due to stocks now moving based on their technicals and fundamentals again–as opposed to moving lockstep with the entire market or their sectors. This phenomenon, or "dispersion," began in the second half of last year and "is accelerating now," said Mulholland, adding that it’s no surprise that portfolio managers would look for capital to lock in alpha in such an environment. "We had a feeling that 2010 was going to be a stockpicker’s year," Mulholland said.
The backdrop for this rise in capital commitment comes while the industry as a whole has experienced a drop in total commissions. The recent Greenwich Associates annual survey shows that commissions were down in 2009 by 13 percent, to $12.1 billion. That’s down from $13.18 billion in 2008, which was a record year.
Although commissions last year dropped from 2008, last year’s numbers don’t appear as bad when considering they were on par with 2007 and 2008’s were through the roof.
One reason for the lower commissions over the last year is that the majority of portfolio managers rode the market upward from the lows of March 2009 and didn’t make many adjustments to their core holdings, several sources told Traders Magazine.
The earnings for Q1 of this year also didn’t provide any major surprises that would have caused portfolio managers to get aggressive in either moving in or out of a position, said one source. Typically, volume will pick up anywhere from 150 to 200 percent during earnings season, but that did not happen at the end of the first quarter this year.
One buyside trader at a large fund said the low volatility might benefit brokers risking capital, but, conversely, the lack of movement in stocks often doesn’t push managers to make decisions. "There is a lot less conviction from PMs in a low-volatility environment, so you won’t see those trades where capital is a great way to start an order," the head trader said.
For the first quarter of this year, institutional business has continued to be tight. One senior sales trader at a regional broker estimated that most firms were down between 10 and 20 percent in the first quarter, compared to the same period in ’09. He said, "We have banking, research, and capital, and it is a battle every day to do business."
That’s one reason why firms are offering capital, to separate themselves from the pack, explained one sales trader at a firm that offers capital and research. "The Street has gotten very competitive again with its capital," he said.
Michael Nasto, head trader at U.S. Global Investors, which manages $3 billion in equities, said there’s nothing not to like about a broker committing capital. "If you can get half your order done, you just decreased your risk," he said. His firm specializes in natural resources and brokers have been aggressive shopping lists of stocks in which they would make two-sided markets.
But not all buyside traders want capital, even if they can get it. For some, it is an issue of their commission budget, as a capital trade cannot be credited to pay for brokerage services. And with commissions tighter these days, with the lower blended rates, every commission dollar really counts.
Still, to get 40 percent of an order into the portfolio "up a few cents is pretty tempting," said one buyside trader. "You need to use capital in the context of your budget, so you can’t always use it."
At the end of the day, capital commitment is about partnerships, traders said. Brokers understand there will be losses associated with the business, but each trade is done in the context of the larger business relationship.
Mulholland of BofA Merrill said there is a lot of dialogue and transparency that is involved in putting together large trades with capital. "We’re trying to offer a solution at the right price to our clients," Mulholland said. "If they need to get a tough trade done, we’re going to do it for them."
