With big honchos from trading firms now at the Hamptons enjoying warm summer sun and chilled unbruised gin, we observed a broad program-trading reset in the equity markets on August 4. Basically, program trading moved assets into less risky securities and head traders gave their underlings defined and controlled avenues to pursue alpha (divergences from norms).
It’s quite something how these resets resemble, say, overnight server updates from your corporate IT department. Algorithmic order flow pauses…and then resumes at a different pace. You veteran readers of the The Map have already heard our goop on program trading more than once. But it’s summer for a few more weeks and we’ve seen quite an increase lately in readership here, so we’ll risk redundancy and revisit how program trading works.
In the simplest sense, programs are real-time versions of mutual funds. They are humanly devised and mathematically implemented schemes for buying and selling baskets of securities at once and continuously, as opposed to investing and de-vesting securities individually and over time. Their chief aim is risk-management, not investment. Programs have been around for several decades, but it’s only since the Internet Bubble that managing risk has become an institutional obsession, demanding shorter term evaluation and portfolio rebalancing.
In essence, attention has turned from studying fundamentals to tracking liquidity and risk; that is, what are the economics of buying and selling and what risks to portfolio performance are inherent to those decisions? This is why Ph.D.’s became more popular than MBA’s on Wall Street, and, really, why, too, that options trading has exploded. Mathematicians like Renaissance Technologies’ founder Jim Simons turned Wall Street’s attention away from balance sheets and income statements to seas of primordial data out of which could be programmatically wrenched a path to controlled risk and leveraged, outsized returns from short-term divergences.
Programs handle the job of rebalancing assets in broad mixes. There are two elements to the process: 1) the efficient means to retain portfolio balance and associated risk; and 2) tools and knowledge for generating additional yield from the very act of rebalancing assets. These approaches also fit how wealth is concentrating in the 21st century, which is in the hands of fewer and larger entities like sovereign wealth funds. It’s very inefficient for gigantic sources of money to pursue, say, high-growth small-cap securities individually. Thus, sellside shops like Morgan Stanley and UBS and Credit Suisse and Goldman Sachs have crafted computerized solutions to help massive institutional money – not just hedge funds – do that.
Long story short, what’s happening in August 2008 is careful risk-management coupled with scattered pursuit of short-term results. It’ll show up in harsher punishment for earnings misses and better rewards for surprises in the near term – and of course, fewer assets chasing commodities. But come September, resets will again occur and it’ll be a whole new game. Oh, and options expire both this week and next, so don’t be surprised if the markets are up one day and down the next.
Margaret E. Wyrwas - Knight Capital Group, Inc. (Nasdaq: NITE)
Senior Managing Director, Corporate Communications & Investor Relations
Equity Analysis™ subscriber since March 2007
"In global markets driven by automation, changing market structure regulation and dynamic investment objectives, today's investor relations professionals require new data points in order to remain relevant and add value in their company's quest to reduce its cost of capital."
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