The Buy-Side Values Short-Trade Ideas

When the Securities and Exchange Commission posted an order last night extending the temporary restrictions it placed on short selling in 19 financial stocks until Aug. 12, 2008, the SEC may have allayed the concerns of asset managers that rely upon short-trade ideas in their strategies.In a statement, SEC Chairman Christopher Cox conveyed that the order was designed to protect legitimate short selling but prevent illegitimate naked short selling and potential 'distort and short' manipulation.' At another point, Cox said the order extension is intended "to protect legitimate short selling that is essential to efficient, highly liquid markets." These are powerful words that clarify the SEC's view on the rulemaking and should assure investors that value short-trade ideas, which are on the rise in these volatile times. With all the hedge funds operating long/short and market neutral strategies and asset managers running 130-30 funds, there are legitimate reasons to be shorting stocks and there is still plenty of interest in legitimate short-sale trade ideas. Judging from statistics released this morning by youDevise Limited, the volume of electronically transmitted trade ideas - particularly short ideas - hit a new record in June. The U.K. based software company operates an alpha-capture system used by the buy-side to receive sell-side recommendations. Today, it announced that the quantity of short-ideas increased 629 percent year-over-year in June of 2008 to 8,081, beating the previous record of 7,894 short ideas established in April of 2008. In June, short-ideas comprised 39 percent of all new ideas put through the Trade Ideas Monitor (TIM) platform.

Year-to-date through the end of June, youDevise saw a 300 percent increase in worldwide trade ideas transmitted from the sell-side to the buy-side through its TIM repository and distribution center, which totaled 20,898, surpassing the previous record of 19,238 set two months ago. The company also added a total of 23 new buy and sell-side participants in June, which is a 156 percent increase over the 9 added in June of 2007. Currently, youDevise has about 150 sell-side firms that are actively contributing ideas to the applications, and about 50 global buy-side firms that are active in allocating a portion of their revenues to reward the brokers for their content.

I spoke to Simon Ellis, youDevise's U.S. Country Manager, to find out what are the reasons behind the surge and how the buy-side is using these ideas. Ellis links the massive growth in trade-ideas and the spike in the number of buy-and sell-side firms participating to market volatility, and in the case of short trade ideas to the market downturn. With market conditions being quite difficult, financial stocks - whether in the U.S. or Europe - were taking a bit of a hammering. Therefore, it was easy to apply a short recommendation on financial stocks, says Ellis.

"Most of the buy side that use this type of application, always ask for short recommendations just because of the downturn in the market itself," says Ellis. I find it interesting that trade-ideas are a global phenomenon in that 50 percent of the ideas submitted are on European listed, 25 percent are U.S.-listed and 25 percent are on Asian-listed stocks. European trade ideas out number the U.S. and Asian ideas because there's a longer use of these types of alpha capture applications in Europe than in the U.S. and Asia,

But there are different usages for the information and not all of it is related to short selling. In the first instance, a growing number of quant global funds or stat arb funds are looking to add the information points to their strategies and some of them are creating separate trade-idea funds, he says. In this case, such funds are basing their strategies on the trade recommendations that they are submitting to their black-box algo strategies they've developed, Ellis told me. Some firms have short-only funds so they are looking for this type-of-content, he notes.

It doesn't surprise me that these quantitative hedge funds are taking a feed from the sell-side contributors directly from TIM into their black-box strategies. Unlike fundamental research managers, these funds "are looking to receive as much content as possible, and therefore the sell-side is quick to react," says Ellis. And they want the volume of ideas from as many sell-side contributors as possible.

Then there are traditional long-only asset managers that want to use the system's metrics to formalize their valuation of broker counterparties. Rather than use regular email or telephone conversations, they want the broker to use a tool that will measure their ideas. Finally, there are hedge fund desks and other trading desks that wish to monitor the contributions and trade directly off the recommendations with the broker in a traditional manner.

The buy-side is trying out the alpha capture system to identify brokers who are going to make them money. This also is appealing since it brings more transparency into evaluating broker relationships. I'm told the platform has metrics which the buy-side can run across different applications and look at historical content to evaluate how a broker's trade ideas have performed over various upturns and downturn in the market.

Also, the brokers are looking to generate value-added advisory services that the buy-side can pay for with research commissions above and beyond executions. Apparently, trade-ideas qualify as a value-added service that regulatory bodies will accept as permissible under the safe harbor 28(e). So whether the trade ideas are long or short they are providing value to the investment decision-making process.

As for the SEC's decision to extend the short selling restrictions, and what impact that would have on the buy-side using these short-ideas, so far the SEC has not extended the ruling to additional financial stocks or the rest of the market. For now it means that buy-side firms will need to arrange to borrow stock in those designated financial institutions at the time of the sale, so that buyers would receive the stock they purchased on time. However, the SEC is considering additional rulemaking to provide additional protections against abusive naked short selling in the broader market.When the Securities and Exchange Commission posted an order last night extending the temporary restrictions it placed on short selling in 19 financial stocks until Aug. 12, 2008, the SEC may have allayed the concerns of asset managers that rely upon short-trade ideas in their strategies. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio