Trade Life Cycle Ecosystem-3 perspectives

Trade life cycle cannot be just explained from either Buy side or Sell side perspective. It has to be viewed in holistically keeping in mind all market participants. Below is presentation of such ecosystem.

Feel free to post any questions.

Low Latency, performance and Active portfolio management

Low Latency, performance and Active portfolio management
People who are working on trading apps or other related apps, hear the term “performance”more often than their own names.
What is the reason that this aspect has become so important and captured the attention of clients all over?
The idea of this blog is to attempt to look into the reasons behind the urgency and rush towards “performance".
We see today that institutional portfolio managers are rushing after so called "Low latency" performance driven trading applications. Gone are the days when portfolio manager would call a broker to work out the trade way he feels is best to do.
With the continued advent of trading technology, now portfolio managers or buy side traders command much more discretion in terms of how their trades should be worked out in market. The goal is simple to achieve ‘best execution’ (which is also the fiduciary responsibility of portfolio manager) and to reign over implicit transaction costs.




Note: There are 2 types of transaction costs: 1. Explicit costs like commissions, fees etc. that is paid over and above trade price 2. Implicit costs which impacts the trade price from the act of trading only and not explicitly determined. A simple example of implicit transaction costs is bid-ask spread.




Well why are we talking about implicit transaction costs here? I thought we gonna talk about importance of low latency apps.

That's right, but low latency actually helps to reign over those implicit transaction costs and one of those important implicit transaction costs is “implementationshortfall” which we will be talking about it here.

Let’s take a look what is implementation shortfall?

Before understanding implementation shortfall first take a look what is paper returns vs.real returns. Paper return is based on “decision price” i.e. price prevailing in market at a time when portfolio manager decides to take a position in a specific security whereas real returns are based on “execution price”; price at which actually trade takes place, which could be different or actually is different from “decision price”. This difference is actually known as implementation shortfall and is real reason for difference is paper returns vs. real returns.

Today traders at buy side firms or portfolio managers are actually working hard to reign into this difference. And the one way(of the many other ways ofcourse) to achieve that is to have low latency and high performance trading apps.

Well there are other arguments also like algorithmic or quant trading which is driving demand for low latency apps. The answer to that question is ‘yes’it is true to an extent but for quant strategies to work ‘low latency’ may not be just enough, that actually requires much more better performance, something called “ultralow latency”which is addressed using co-location services.

Okay…. the implementation shortfall argument looks fair enough…but why the hell active portfolio management is doing here?

The answer is “alpha”….the whole theory of active portfolio management lies on premise of “alpha”.

Just to remind (or people who are not aware of this term), “alpha” is the extra return that portfolio manager earns over benchmark, in portfolio management world it is also known as “Active return”. But before we go further on active portfolio management we should realize the fact if there is “Active” then there is“passive” portfolio management too
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Let’s understand this….consider yourself a very high net worth individual say having 10$ million, now you have 2 options….first option is to invest in some market indices say DJIA (Dow Jones industrial average) with same underlying i.e. same set of 30 stocks which forms ‘DJIA’ carrying same weight. For example, ‘American Express’ is one of the component stocks of DJIA so you buy’ American Express’stock too carrying weightage equal to weight in ‘DJIA’.By doing so, you have actually invested in a broader market and whatever DJIA return is, your return will be same. And moreover you don’t have to pay any portfolio management fees or any other related charges

Well, then why investor would seek portfolio management services, the reason is investor looks for “alpha” that extra return which they expect their portfolio managers to earn and for that they are ready to pay portfolio management and performance fees..

Therefore portfolio managers always seek to run behind that “alpha” otherwise there will be no point of active portfolio management and portfolio managers will lose their jobs …and low latency and performance driven trading apps in one of the many ways to capture that “alpha”,that extra return that extra bit….and if you still wonder;’ How’?

Go back and read the implementation shortfall above

Note: There are other aspects of active portfolio management also which is beyond the scope of this specific blog. In case if some one wants to discuss other aspects related to active portfolio management or transaction costs or have any other queries to related topics like how weight is determined in diferent types of indices( eg Price weighted vs Equal weighted), then please drop me a note or post your comments, and I will try my best to respond to it.