Hedge Funds to Boost Use of Trading Algorithms for Stocks, Tabb Group Says

Asset managers such as hedge funds will probably increase their use of computer programs known as algorithms to execute their stock trades in 2011, according to securities-industry research firm Tabb Group LLC.

The proportion of orders processed by algorithms will probably amount to 35 percent next year, up from 29 percent in 2010, according to a report from Tabb analyst Cheyenne Morgan and director of research Adam Sussman. Human traders at broker- dealers will execute 35 percent of orders in 2011, down from 39 percent this year, the report said.

The growth during the past decade of electronic trading that allows investment firms to exert greater control over their orders has diminished the importance of sales traders at securities firms. Sales desks will generate $9.5 billion of the $15.3 billion in equity commissions paid to brokers this year, compared with almost $3 billion paid for algorithms, Tabb said. Algorithms break larger orders into pieces, executing them over a set time period to help ensure customers get the best prices.

“In 2008 and the beginning of 2009, buy-side traders turned more to sales traders for guidance and advice about how to navigate the market, but that trend has reversed,” Morgan said in an interview. “During the financial crisis they also became more comfortable with how algorithms performed.”

Record VIX

Expectations for volatility in U.S. equities peaked in November 2008, two months after Lehman Brothers Holdings Inc. filed the biggest bankruptcy in the nation’s history. The Chicago Board Options Exchange Volatility Index, or VIX, which measures the cost of using options to protect against declines in the Standard & Poor’s 500 Index, closed at a record 80.86 on Nov. 20, 2008, and has retreated about 67 percent since then.

The Tabb study is based on interviews with 66 head traders at investment management firms with a total of $12.1 trillion in assets and 57 head traders at hedge funds with $182.1 billion. In the former group, 52 percent managed less than $50 billion, compared with 36 percent in 2009, New York-based Tabb said. Large firms, defined as investment companies overseeing more than $150 billion and hedge funds with more than $3 billion, accounted for 86 percent of total assets in each group.

The top five providers of algorithms to asset managers and hedge funds are Credit Suisse Group AG, Investment Technology Group Inc., Bank of America Corp., Goldman Sachs Group Inc. and UBS AG. Credit Suisse trading strategies are used by 69 percent of firms, the study found. Algorithms from Sanford C. Bernstein & Co. are used by 19 percent of firms and those from Weeden & Co. by 13 percent. The report described the latter two firms as “winners” among mid-tier brokers.

Commissions

The estimated $15.3 billion asset managers and hedge funds will pay brokers in equity commissions this year is up slightly from $14.9 billion last year, the report said. The firms paid $17.2 billion in 2008. Asset managers accounted for 73.3 percent of those fees, down from 74.6 percent in the two previous years.

Traders at the firms surveyed will manage 9 percent of their volume themselves next year -- the same as this year -- by placing orders directly on exchanges in what’s called direct market access, the report said. Their use of crossing networks and dark pools, or private venues that don’t display quotes publicly, will rise 1 percentage point to 13 percent in 2011, Tabb said.

Brokers get 3.2 cents per share from hedge funds using their sales trading desk, compared with 2.9 cents paid by asset managers. Hedge funds pay higher commissions than asset managers for sales trading, direct market access, dark pool executions and baskets of stocks sent to so-called program desks at broker- dealers. The only category in which hedge fund rates are lower is algorithms, for which they pay an average 0.9 cents per share, compared to 0.7 cents paid by asset managers.

Low Touch

Commissions to sales desks have “probably hit bottom” while investment firms are likely to “demand more services on the low-touch side,” Morgan said. Low touch refers to the use of electronic trading tools. Sales traders at some brokers will need to provide more guidance to customers about how and when to use algorithms, while at others that advice may come from people staffing electronic desks, she said. “The buyside will also want more market color from low-touch desks,” she added.

Goldman’s Sigma X dark pool is used by 33 percent of the study participants, followed by Credit Suisse’s Crossfinder at 24 percent. Aqua, a system for transacting larger trades than are sent to stock exchanges, and UBS’s PIN dark pool are used by 20 percent of firms. Morgan Stanley’s MS Pool has connections to 17 percent of the firms surveyed, Tabb said.

To contact the reporter on this story: Nina Mehta in New York at nmehta24@bloomberg.net.

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