Motivations to Trade

Portfolios must be created and maintained to reflect the risk/return characteristics of the ultimate beneficiaries. This section discusses the different reasons why managers need to trade. While active managers have more motivation to trade, even passive managers will need to do some amount of trading. The main motivations to trade are as follows:

• Profit-seeking.
• Risk management/hedging needs.
• Cash flow needs.
• Corporate actions/index reconstitutions/margin calls.

Profit Seeking

Trade Urgency

This is the most common motivation for active managers. When a perceived mispricing is uncovered, and the manager transacts to earn alpha from it. Some managers believe that the information leading to the mispricing will be uncovered quickly by the market and thus dry up. This refers to the urgency of the trade. Urgent trades are ones that managers believe will disappear quickly. A term to describe this phenomenon is alpha decay, which refers to excess market returns disappearing due to the leaking of information.

Market Impact and Trading Transparency

Managers and traders often want to hide their trades by using less transparent venues. This is because they believe that the information about orders they may place will exacerbate the disappearance of the opportunity (i.e., If a large hedge fund wants to sell many shares of a certain company, they must be overpriced). To hide their trades, managers often use dark pools, which are available only to select clients and provide far less transparency, reporting only post-trade transactions and quantities. While dark pools do a good job of keeping certain information private, the probability that orders go unfilled is higher with a smaller pool of potential traders.

Time Horizon and Trade Urgency

Managers with a longer-term view, commonly using fundamental analysis, will still aim to ‘beat the market’, also known as earning alpha, but will have much less trading urgency. If shares of a company are to be held for many years, trading can be done in a patient manner. If a manager wishes to trim back holdings of a large position without giving away information to the market, they may do so slowly, over time, and thus not cause any market impact.

Risk Management/Hedging Needs

Many portfolio managers need to monitor their portfolio's risk levels and adjust accordingly. A fixed-income fund, for example, may have the target duration that it needs to stay within. This may mean rebalancing at regular intervals to stay within this pre-determined range.

The portfolio's Investment Policy Statement (IPS) should specify the risks to be hedged and the allowable instruments. To hedge risks or rebalance, managers may need to trade underlying securities or use derivatives. Equity futures like S&P 500, FTSE 100 Index, or Nikkei 225 futures, and short-selling underlying shares are common methods. For fixed-income portfolios, using Treasury futures like T-bond futures might be allowed. If a manager lacks this flexibility, they may need to adjust the long/short positions or use cash to achieve the desired exposure.

For quantitative funds, targeted volatility is usually explicitly stated in the fund's offering documents and will need to be maintained throughout the investment horizon. Portfolio managers should understand target risk levels and when changes in the market environment might require trading to adjust portfolio risk back to targeted volatility.

Managers may also choose to hedge certain risks away without a profit-seeking motive. For example, a global fixed-income portfolio manager may trade in currency pairs in order to eliminate currency risk in the portfolio, whether or not they have a view on that currency pair. Options may also be used to this end, such as an equity portfolio manager who purchases or sells a straddle in order to adjust exposure to volatility.

Cash Flow Needs

Cash flows into and out of the portfolio may give rise to the need for additional trading beyond what was initially expected. A large inflow is sometimes equitized, a process by which derivatives are used to establish the equivalent exposure of the dollar amount of the inflow where it is to be directly invested. The manager may then begin to trade out of the derivatives and into the underlying as portfolio rebalance dates arrive.

Many hedge funds have lock-up periods, which can protect the fund managers from having to meet urgent, last-minute redemptions that could jeopardize their strategy. On the other hand, managers using margins may have to liquidate positions extremely quickly in order to meet a margin call.

Corporate Actions/Index Reconstitutions/Margin Calls

Trading may also be necessary due to such activity as corporate actions and operational needs (e.g., dividend/coupon reinvestment, distributions, margin calls, and expiration of derivative contracts).

Long-only managers may manage funds using a market-weighted index as a benchmark (e.g., the S&P 500, the MSCI World Index). If the benchmark constituents change, it could affect the manager's desired portfolio composition. If the manager runs an active portfolio, in the case of a change in index constituents, the manager might choose to sell holdings in a security that has been removed from the benchmark index.

Question

Dark pools are used mainly to?

1. Reduce market impact.
2. Reduce regulatory burden.
3. More quickly, find a suitable counterparty.

Solution

The correct answer is A.

Reducing market impact is the aim of dark pools. Many traders of large amounts of securities do not want to give information away to the market that would be conveyed using traditional public exchanges, as this could reduce alpha.

B is incorrect. Regulations are the domain of the government; the extent and intensity to which they apply to financial intermediaries cannot be determined by the use of alternative markets for securities trading, such as dark pools.

C is incorrect. Using a dark pool is actually likely to increase the amount of time needed to find a suitable counterparty. This is because dark pools are private exchanges and invite-only. They have smaller membership.

Reading 11: Trade Strategy and Execution

Los 11 (a) Discuss motivations to trade and how they relate to trading strategy