Hedge Funds Warm To Trading Tools

The hedge fund industry is undergoing a major transition - large firms are turning into financial services franchises and small firms are struggling both to raise assets and run a successful fund. The competition to produce high returns has become fierce and survival depends on it. The largest funds are able to leverage their size to lower their costs in securities lending and diversify into multiple asset classes. The challenge for the smaller funds, and even some large fundamental shops, is to effectively use their assets to match or surpass their larger competitors. Technology affords them this rare opportunity.

The two major areas of technology that have taken center stage in the equities market are direct market access (DMA) systems, including the use of broker algorithms, and transaction cost analysis (TCA). DMA allows a trader to interact directly with the market without the involvement of a trader or even a broker's order management system, both of which can slow down the speed of execution. The use of TCA has increased in importance as traders, their managers and their clients want to know how traders or their brokers are executing in the market. While not all funds are using these tools, the ones that are stand a better chance of success in the marketplace.

In The Tabb Group's recent report, "Hedge Funds 2005: An Inside Look at Funding, Servicing, Trading and Technology," we found a tremendous interest in DMA and algorithmic trading tools, but uncertainty about how to select and use them. For the report, The Tabb Group spoke with 63 U.S.-based hedge funds, including 18 with assets of more than $1 billion. According to respondents, both DMA and algorithms were helpful to traders in managing their workload, though DMA systems stood out by allowing a trader to access the market with the most control. While only 19 percent of hedge fund orders are sent to DMA and 10 percent to broker algorithms, traders clearly prefer these methods to any other. When given a choice of how to trade, 81 percent of respondents said that they preferred DMA or broker algorithms to any other trading method (see Exhibit 1, at right).

While the hedge fund community clearly is very interested in these trading tools, many funds reported that they are still experimenting with different DMA systems and broker algorithms. Sales and sales trading relationships are playing a large role in the decision-making process (see Exhibit 2).

At a number of funds, the line between direct market access and broker algorithms still is blurred. This is happening in part because many broker algorithms are connected with multiple order management and DMA systems. Some funds also consider smart order routing to be an algorithm, while others think that algorithms are the same as DMA. As time goes on, however, brokers and technology service providers likely will educate their hedge fund clients about how to best use each product for maximizing returns.

The other area in which technology can make a real difference is transaction cost analysis. TCA in the hedge fund world has a substantially different history than for traditional asset managers, where it mostly has been used to show plan sponsors and investors that traders were meeting their fiduciary responsibilities. For hedge funds, TCA has been more a means of checking the quality of their execution in the market and working to integrate results into the traders' decision-making process. For all the talk in the market, traditional asset managers only now are beginning to catch on to this idea.

TCA for hedge funds has grown into a combination of pre- and post-trade analyses focusing on incorporating historical data, tick-level trading activity and competing statistical methodologies. With no industry standard, funds are developing tools in-house or using vendor offerings to establish metrics to evaluate their executions and track them consistently over time.

While only 34 percent of funds currently have TCA capabilities, another 21 percent are planning to add TCA or know that this is something they need to attend to (see Exhibit 3). Measuring best execution or installing TCA also is the No. 1 way that hedge funds are planning to improve trading over the next two years (see Exhibit 4).

The Tabb Group's research has found that hedge funds by and large do not face challenges in using technology once they understand it, but the curve to adopt these tools effectively can be steep. The largest multi-asset class hedge funds already are adept technology users and have been for some time. The smaller funds, along with some large single-asset class managers, that can learn to use technology will be the most likely to survive and thrive in the competitive hedge fund landscape. Direct market access and transaction cost analysis will lead the way. b

Our Analyst

Josh Galper joined The Tabb Group in 2004 as a partner. His expertise centers on strategic business development for financial technology and sell-side firms, including partnerships, acquisitions, licensing and distribution. Additionally, Galper served as head of electronic trading at Sanford C. Bernstein and as a vice president in the institutional division at Merrill Lynch.