Tuesday, April 21, 2009

The Arms Race in High Frequency Trading

If the calls I am getting from headhunters are any indication, the hot area now is high frequency trading. And no wonder. There are two areas that were spared in the 2008 debacle: macro and high frequency trading. Macro funds on average were up ten percent or so last year because most of them skirted the edge of the major dislocations; their strategies focus on liquid instruments and are not oriented toward credit. High frequency trading did well because it thrives in an environment of high volatility and demand for liquidity, and 2008 was a hot house for both. Every year, people pile on to whatever strategy did well the previous year – this tendency is worth a book or two on its own – and so this year high frequency is destined to be the darling of the fund of funds.

But I think the days for high frequency trading are numbered. For one thing, high frequency trading is capacity constrained like few other strategies. The high frequency trader is basically a stand-alone market maker; he is sitting there to provide liquidity to others. And one way he provides it is to pull in the positions that others will shortly be demanding – thus the need for speed. If the footprint for high frequency traders gets too large, they become liquidity demanders themselves, and the gig is up. The Renaissances of the strategy will make their way through, but generally we will see a lot of shooting stars.

A second reason is that high frequency trading is embroiled in an arms race. And arms races are negative sum games. The arms in this case are not tanks and jets, but computer chips and throughput. But like any arms race, the result is a cycle of spending which leaves everyone in the same relative position, only poorer. Put another way, like any arms race, what is happening with high frequency trading is a net drain on social welfare.

In terms of chips, I gave a talk at an Intel conference a few years ago, when they were launching their newest chip, dubbed the Tigerton. The various financial firms who had to be as fast as everyone else then shelled out an aggregate of hundreds of millions of dollar to upgrade, so that they could now execute trades in thirty milliseconds rather than forty milliseconds – or whatever, I really can’t remember, except that it is too fast for anyone to care were it not that other people were also doing it. And now there is a new chip, code named Nehalem. So another hundred million dollars all around, and latency will be dropped a few milliseconds more.

In terms of throughput and latency, the standard tricks are to get your servers as close to the data source as possible, use really big lines, and break data into little bite-sized packets. I was speaking at Reuters last week, and they mentioned to me that they were breaking their news flows into optimized sixty byte packets for their arms race-oriented clients, because that was the fastest way through network. (Anything smaller gets queued by some network algorithms, so sixty bytes seems to be the magic number).

If we get out of the forest and look at what is going on, some questions come to mind. Does anyone really get a benefit in having the latency of their trade cut by milliseconds – except for the fact that their competitor is also spending the money to cut his latency? Should anyone care if a news event hits market prices in twenty-nine milliseconds rather than thirty milliseconds? Does it do anything to make the markets more efficient? Does it add any value to society?

We usually do not think about trading in terms of social value, but trading often does have social value, and it should. The objective of trading is to provide liquidity to the market, and to make sure that prices best reflect all available information – the usual efficient market argument we all grew up with. The solution? How about having everyone agree to standards in terms of hardware and related configurations. A high-frequency arms limitation treaty. We could call it HALT.

Wednesday, April 1, 2009

Measuring the value-added of hedge funds

The co-heads of Goldman’s Global Alpha hedge fund, Messrs. Carhart and Iwanowski, are calling it quits. A few years ago I was running a hedge fund at FrontPoint Partners and we were bought out by Morgan Stanley just in time to attend MSIM’s annual managing directors meeting. All they talked about at that meeting was what MSIM could do to be more like Goldman’s Global Alpha. It was a fierce machine, the gold standard. And it had some years of stellar returns. They rode their hedge fund up to a peak of $12 billion a couple of years ago. Since then they have seen it shrink to $2 billion.

If you are Carhart and Iwanowski, or for that matter AQR’s Asness or Citadel’s Griffin and have a really bad year, at least you can gain some solace by saying to yourself, “Things didn’t roll my way this year, but still, since inception I have on average delivered 15% returns.” Or putting the same sentiment differently, “Even though this has been a hard year, if you had invested $10,000 with me when I started, it would still be worth $300,00 today.”

Actually, no. If you use those benchmarks to define your career as a hedge fund manager, you are doing it wrong. Because hardly any of your investors did put their money with you way back when. In fact, most of them put their money with you over the past three or four years, years where returns moved from hum-drum to disastrous.

I have a hypothesis that would be easy to test with the right data: Some of the large hedge funds that have drawn down substantially in the past year or two have on net lost money for their investors since inception. This, even though they have collected huge fees and have decent average annual returns. The reason I think this might be the case is that in the current downturn they had a lot more money under management, and so had more dollars to lose per unit of poor performance, than when they were knocking the cover off the ball in their early years. Some of the hedge funds that are on the ropes grew larger and larger over time, reaching elephantine size just in time to implode. Some of these were starting to stumble under their own weight in the years before that.

A performance statistic to gauge the overall economic value-added for hedge funds is capital-weighted annualized returns. It would help to answer the question of a hedge fund’s – or the hedge fund industry’s – life-time economic value added; it would be useful even for large hedge funds that have not struggled the way that Global Alpha has. I don’t really care as much about what a $20 billion dollar fund did ten or fifteen years ago when it had $1 billion than how it did in the more recent years when it was trying to put these larger levels of capital to work.