Picture this: you can protect your investments against the aggressive high-frequency trading (HFT) right in your portfolio. "What?" you may ask. With the latest technology from AbleMarkets, now available on Quandl, hedging aggressive HFT is no longer just wishful thinking, but a reality.
How is hedging aggressive HFT possible? First, to hedge aggressive HFT exposure, one needs to know what that exposure is. AbleMarkets aggressive HFT Index summarizes the daily participation of aggressive HFT as a percentage of the total daily volume traded in 90% of the active U.S. stocks (those comprising the Russell 3000 index). Using proprietary technology, now nearly 10 years in the making, and the robust information platform underlying the production, AbleMarkets can reliably estimate what proportion of traded volume was initiated by aggressive HFT buyers and sellers. This is the first application of its kind and already a great success among fund managers.
Why does one need to hedge aggressive HFT? You may have heard of HFT, sometimes referred to "high-speed traders". While some research points out that the effect of the HFT is not uniform, other research shows all HFT comprises two drastically different types: aggressive and passive. Passive HFTs tend to use limit orders with an overall benign effect, reducing volatility and improving liquidity. Passive HFTs are the new, electronic market makers that essentially have taken on the duties of the human market makers of the past. Unlike the passive HFTs, aggressive HFT mostly rely on market orders and, as a result, have a harsh effect on the markets, increasing volatility and wiping out liquidity. These liquidity-taking HFT strategies respond to short-term information inefficiencies, such as premium news sources, and possess what's called rapidly-decaying alpha. To take advantage of this fast-vanishing alpha, aggressive HFTs need to trade immediately after the time the signal comes in, and market orders provide a perfect conduit for such fast trading. Ultra-fast technology, of course, is underlying the entire process.
The aggressive HFT activity across all of the Russell 3000 stocks cost investors a pretty penny, AbleMarkets research finds. On average, buy-and-hold strategies across the Russell 3000 over 2013-2015 timeframe produced annualized volatility of 8%. Adjusting the portfolio holdings by the Aggressive HFT index (reducing the holdings in stocks with high aggressive HFT participation and increasing holdings with a low aggressive HFT (data can be downloaded from Quandl) does not do much to the stock returns, however, it does reduce volatility from 8% per annum to 6% per stock, on average. This minor tweak improves the average Sharpe ratio across individual buy-and-hold stock strategies by 50% per annum, improving portfolio stability and capital allocation, not to mention viability of various long-term options strategies. Doubling down on the stocks in proportion with their aggressive HFT participation helps reduce average buy-and-hold volatility further to 4% per stock, and doubling the average buy-and-hold stock Sharpe ratio in the process!
How does this translate into real dollars? If you are a fund manager with a concentrated buy-and-hold position of well-screened stocks and you would like to incrementally improve the appeal of your strategies - this is for you. As most managers know, the difference of a Sharpe ratio of 1.50 and 3.00 is arithmetically small, yet potentially huge in the eyes of prospective investors, making a difference between single-digit millions and, potentially, billions in Assets Under Management (AUM). In a nutshell, the higher Sharpe ratio delivers more stability of the fund performance and, as a result, enables managers to secure more capital. Accounting for aggressive HFT activities helps lead the way to a better business.
Irene Aldridge is Managing Director, Head of Research and Development, AbleMarkets.com and Able Alpha Trading, LTD. She is the author of High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems (2nd edition, Wiley, 2013). She can be seen at the Big Data Finance conference at New York University on May 19 and 20, 2016. Irene can also be reached at Irene@AbleMarkets.com