Philip Orlando, a senior portfolio manager at Federated Investors, has
a dedicated phone line that connects him with Diane Startari, the trader who handles his large-cap orders. He talks to Startari or e-mails her many times a day.
"Diane is very much a partner and collaborator in what I'm trying to do," said Orlando, who adds that she has full discretion over his trades.
"She knows the other side of the trade better than I do. I'm not going to take bullets out of her hand."
Buyside traders, often regarded in the past as second stringers by portfolio managers, are finally overcoming their inferiority complexes. Regulatory, economic and technological changes that have transformed the equities trading marketplace over the last decade have spilled over into the workplace. They have redefined the relationship between traders and portfolio managers.
Improving Returns
For starters, traders play a greater role in helping buyside money managers improve returns. And there's a lot to improve. The average domestic equity fund was down almost 21 percent in 2001 and was little better in 2002. Although stock funds made a recovery last year, there's still a lot of damage to repair, especially on the Nasdaq side.
"In the triangle of portfolio manager, analyst and trader, the trader was not always considered a professional equal," said Joan Stack, trading manager at the Ohio Public Employees Retirement System (OPERS), a pension fund with $59 billion under management. "But as the markets have become more demanding and the technology more sophisticated, the trader has been forced to achieve the same level of sophisticated professionalism as managers and analysts," Stack added.
In the past, traders often arrived from the operations side of the business – from securities settlement, stock loan services or other areas that touched peripherally on the trading process. Now they increasingly come out of MBA programs or are encouraged to work towards a CFA designation.
One reason for the change is decimalization. Because block trades are more difficult to execute, traders now need more market expertise and knowledge of electronic communications networks (ECNs) and other venues. More complex markets require faster and more fine-tuned decisions.
For traders, the key to the changing role is technology. At most institutional money management firms, just about the entire trading process – from order generation and management to trade execution and transaction-cost analysis systems – has gone electronic.
Today, many portfolio managers enter orders directly into an order management system. If not, they write a ticket, which is entered into the system by an assistant or a trader. Then the order typically stays in the OMS, where its execution, even in multiple venues, can be monitored and benchmarked by the trader.
The trader's decision about how to handle each order is critical to the price and the speed of execution. "If a trader consistently executes in one particular marketplace because they're unknowledgeable, that's going to show up in the transaction cost analysis because they're missing liquidity," said Paula Peter, manager of equity trading at Pittsburgh-based Mellon Private Wealth Management, which has $35 billion.
"It's crucial that buyside traders stay up on technology and understand and use various trading strategies," added Peter. "In other words, that traders execute some of the order flow themselves in addition to utilizing traditional execution sources."
More Analysis
The expanded role for traders is "the result of better, faster, cheaper technology," according to OPERS' Stack. "We're able to measure and quantify things it wasn't possible to measure years ago, from capturing tick data on the tape to analyzing trades."
This, combined with the poor market environment of recent years, has caused money managers and traders to spend more time studying costs and performance leakage. The guidelines on best execution and trade execution practices, from the Association for Investment Management and Research (AIMR), has propelled this trend.
"The recommendation by AIMR to look at the cost of execution – the total transaction cost, implicit and explicit – was the primary driver for investment advisory firms as well as others to start looking at transaction costs," said Mellon Equity's Peter.
Money managers, of course, also want to be on the good side of the Securities and Exchange Commission, as well as customers "who are becoming much more astute in their questions and who want to see, often from an independent party, where their particular money manager is executing and how effectively they are doing it," Peter said.
Decimalization, by making the market for large orders less liquid, has also made a trader's judgment more important. In a decimalized market, traders are reluctant to show size. In large part, they are afraid of being pennied. This can happen when, for example, an institution sends a limit order to buy 50,000 shares of Stock A at $20 a share. A customer on the opposite side may want to buy the same shares at the market price but a floor broker, sensing a rising market, snaps up the order at $20.01 a share. By pennying the order, the floor trader hopes to sell the shares later at a higher price. This forces institutions to chop orders into many smaller pieces in order to minimize the market impact of trades.
Advanced technology – and an unprecedented growth in program trading – has created opportunities on the buyside. It's another reason why the relationship between traders and portfolio managers has been transformed. These systems enable buyside traders to perform part of the role traditionally played by the sellside. For example, buysiders can decide whether to benchmark an order to the stock's volume-weighted average price (VWAP), or weigh up what percentage of its average daily volume to trade. With these tools, traders are often in a better position than portfolio managers to make decisions about strategies and execution venues.
Many of the portfolio trading and algorithmic tools used – systems such as FlexTrade and TradeFactory from Spear, Leeds & Kellogg – are promoted by sellside trading desks. Then there are ECN aggregators such as Lava Trading and Sonic Financial. "A sellside firm will give you [access to various] systems in the hope that you'll trade with them," explained one buyside trader. "If you stop trading with the firm, someone from sales coverage will call you up and politely remind you that he gave you the toy."
The biggest benefit of technology, says George Bodine, director of trading for General Motors Asset Management, is that it permits more quantitative trading. "If a portfolio manager gives me a package to trade – say 150 names on the buyside, 150 on the sellside, and the value is $100 million per side – I can run an analysis and come up with an assessment of what the impact cost is going to be," he explained. "Based on that I can drill down and see which constituents are going to be the most costly, and I can extract or substitute certain names." This makes trading more efficient, easier and cheaper, Bodine said.
"In the past, we did not have the technology we now have on our desktop for list trades," added Startari, the equity trader at Federated Investors, a Pittsburgh-based company which has $194 billion in mutual fund assets. "We had to create a file in Excel, send it out by e-mail, and figure out how to trade the list throughout the day." Electronic systems help her optimize these trades, giving her more control over orders while maintaining greater anonymity than was possible when she had to rely more heavily on brokers.
While buyside traders have become better at sourcing liquidity, the role of portfolio managers has also changed. Stack, of OPERS, notes that portfolio managers cannot easily stay up-do-date with the entire spectrum of execution venues available. At the same time, the markets are moving faster and are often more volatile, forcing managers to spend more time working on their portfolios.
Many portfolio managers now devote more time to marketing. The biggest change over the last 15 years is the increased need for managers to have more contact with current and potential clients, notes Orlando, the senior portfolio manager at Federated Investors. But this trend may be separating portfolio managers from some of the critical trading decisions they had once made.
"I often have to be out of the office, away from my screen, in order to meet with a client or group of clients to explain what we're doing and make sure they're comfortable with the style and strategy," Orlando said. "That allows, or forces me, to rely much more significantly on my trader, who's sitting in her office in front of her screen watching my markets."
Best Execution
While technology has put buyside traders in the catbird seat, it's trade-cost analysis that has opened the eyes of managers, says Mellon's Peter. It has made managers aware that handcuffing a trader – and giving him limits or specific instructions – hampers best execution.
Corey Geog, senior securities trader of pension fund State Teachers Retirement System of Ohio, stresses the importance of having a third party conduct the transaction cost analysis. "We do a good job in our trading room and have an objective way to show portfolio managers that we are adding value," he said. Many traders echo Geog, noting that Plexus Group, Abel/Noser, ITG Inc. and Ekins/McSherry provide objective analyses that can improve execution quality.
However, not everyone agrees that trade-cost analysis has been good for the trader's and portfolio manager's relationship. Sure, many report that there's far less antagonism in the air. But Chris Orndorff, a managing principal at Payden & Rygel in Los Angeles, suggests that friction between traders and portfolio managers is actually on the rise, particularly in the mutual fund industry. In his view, this is largely because of the trend toward mutual funds paying bonuses to portfolio managers based on investment performance.
"Part of the problem is that portfolio managers put a lot more pressure on traders than they used to," Orndorff said. "Some traders now are being gauged based on beating VWAP or other metrics." Instead of the trader and portfolio manager working together as a team, they can end up in an adversarial relationship. "At some firms, it turns into a finger-pointing exercise," Orndorff added.
Trade analysis can sometimes be used as a crutch or a tool for assigning blame. In some cases, a trader may grumble that a portfolio manager didn't get an order down to the trading desk early enough in the day to sell a stock at a certain price, or that the order wasn't clear enough in terms of its limits. A trader may also draw a trade out over a few days to beat VWAP, when a quicker execution would benefit the fund more.
Traders are also under increasing pressure because of the "continued inability of my side of the desk to outperform our benchmarks," said Ted Aronson, a partner and portfolio manager at Aronson+Johnson+Ortiz LP. As a result, clients focus on two of the main reasons for underperformance: asset fees and slippage' because of transaction costs. This slippage can now be measured more accurately. However, added Aronson, portfolio managers may finally be forced to change due to the recent industry scandals. "Soft dollars and other sleazy practices [that increase implementation costs] have been brought to light and they are not going to last," he said.
In addition to the focus on best execution, the value of information has become more critical. Payden & Rygel's Orndorff argues that, as equities trading has become increasingly opaque and difficult, portfolio managers must use traders more as their eyes and ears. Orndorff likens cash equities trading to bond trading, which is an entirely over-the-counter market and therefore not transparent.
"In a funny way, stock trading is moving towards that, because the more you go to OTC markets and ECNs, the more fragmentation there is and the more the information becomes important – because the specialist isn't the only one who has it," Orndorff said.
Portfolio manager Mary Lisanti, who runs AH Lisanti Capital Growth Asset Management Group, says that she has always relied on traders for market information. However, the rise of hedge funds makes this even more important. A trader with strong broker relationships, for example, may be able to tell a manager whether a stock is down because a large fund is selling it, or because it broke its 50-day or 150-day trading average.
"It's important to know who's buying and selling because you like to see stocks in what you call strong hands,'" Lisanti said, referring to long-term investors. "Also, if a stock is in the hands of momentum players, then when it gets to a certain price or when a particular action happens technically, they're going to sell it. That's the kind of thing you want to know."
The recent increase in covered call writing, and other hedging strategies, also makes it useful for traders to follow the options market for the manager. As the recent collapse in the bull market in equities demonstrated, it became more common for funds to hedge large positions. A fund, for example, may buy 10 million shares of IBM and hedge some of the risk with put options. This is part of a move to separate alpha. This measures a fund manager's ability to outperform a benchmark, from beta, a measure of a fund's volatility relative to the market.
Derivatives Markets
The derivatives markets can also sometimes indicate a market move a couple of days in advance. Lisanti points out that, a number of times just before the market took off, the futures and options markets provided a signal. With players unwinding defensive positions, there was more demand for index options. "When the market turned last spring, people were buying beta, so they were buying options on the Nasdaq 100, the Semi HOLDRS, the iShares and so on," Lisanti said.
Traders can sometimes gather this information more easily than managers. "The counterparty on all of those trades are the Wall Street firms, the broker dealers, and traders are talking to them all the time," Lisanti said. Portfolio managers are sometimes out of the loop. They are often talking to the salespeople, analysts and companies – not the trading desks that have the precious information that can turn a trader into a star.
