As I wrote in “Passive Investments Squeeze Profits for Asset Managers,” which ran in II’s October issue, traditional money managers are being hit from all sides. First, they’re getting slagged by passive managers for charging high fees without beating their benchmarks. In addition, they’re being punished by investors for not maneuvering out of the way of the credit crisis tsunami. On top of that, they’re being assaulted by competition from hedge funds — even on the heels of a bitter year for alternatives.
Now they’re being taken down by high-frequency traders, including such firms as Goldman Sachs and Citadel Investment Group, that use mathematical algorithms and supercomputers to buy and sell shares in microseconds to earn small profits on market inefficiencies. Over thousands of trades, the strategies have been enormously profitable. But the practice has come under fire this year by those who claim it leads to manipulation and unstable markets.
A study released in early December by New York-based Investment Technology Group, which runs a dark pool exclusively for buy-side firms, found that buy-siders are getting a raw deal as dark pools increasingly open their gates to high-frequency traders to attract trade volume.
Buy-side firms have gravitated to dark pools to further protect the confidentiality of their trading activities. That’s not just academic: Investors in mutual funds, for instance, are hurt when traders sell a stock just after a Fidelity or Vanguard has bought a huge block of that same stock. The fund company likely pushed up the price along the way.
But there’s a downside to these dark pools, too. Buy-siders are probing for natural liquidity for long-term trades, while the high-frequency firms are following short-term signals detected by complex and expensive mathematical trading programs. The problem for these buy-side traders is known as adverse selection. On a listed exchange, orders are executed immediately. But in dark pools, buyers can wait up to 10 minutes for sellers to do the deal. After execution, the buy-side trader may come across a buyer willing to pay more, but it’s too late. Such adverse selection could result from a high-frequency trader capitalizing on a momentary low price on the stock.
“It’s a zero sum game for all customers together in a dark pool,” says Hitesh Mittal, managing director at ITG, which developed liquidity filter technology to measure the performance of the dark pool and gauge the presence of high-frequency traders. “Dark pools are supposed to help you because they don’t leak information about your trading activity,” says Mittal. “We needed to protect that advantage.”
With equity returns expected to be in the low single digits for the next year and the economy still on shaky ground, every basis point counts. Already under pressure over fees, money managers can’t afford additional trading costs — and Mittal estimates that a $5 billion fund that turns over its portfolio every year, which is not uncommon in the fund world, could lose $6 million annually to adverse selection.
Larry Tabb, CEO of the Tabb Group, estimates that the annual aggregate profits of high-frequency trading strategies is more than $21 billion. Those profits come directly from buy-side institutions at one and two cents a transaction. Traditional money managers and other buy-side firms are facing a future of fee pressure, increased scrutiny on whether they provide true alpha and transparency. But, they also have to ensure they’re keeping as much of their returns as possible through airtight trading practices. Dark pools can offer advantages, but buy-siders have to beware.
The Alpha / Beta blog is devoted to news and insights about the alternative investment (Alpha) and the traditional asset management (Beta) industries. Institutional Investor staff writer Imogen Rose-Smith covers hedge funds, private equity and their investors. Julie Segal is an Institutional Investor staff writer covering money managers and pension funds, foundations and endowments.
