Algorithmic trading, or simply algo-trading, is becoming common place amongst hedge funds as they continue to position themselves in equities with automated trading in currencies. While global markets continue to struggle due to unpredictable economies, the currency market has become one of the prime candidates to provide hedging opportunities.
Most hedge funds have historically identified themselves with equity investments, but according to recent data, the picture appears to be changing as more players continue to expand their portfolios by including automated currency trading.
This move has seen more hedge funds engage in quantitative trading than before, and according to a list released by Institutional Investor this May, six of the top eight performing hedge fund managers in 2015 are quants.
The list, which featured renowned hedge fund managers, Ken Griffin of Citadel, Jim Simons (Trades, Portfolio) of Renaissance Technology, and John Overdeck and David Siegel of Two Sigma, indicates that quantitative trading, sometimes referred to as high-frequency trading, has helped hedge funds to hedge against losses incurred on positions taken via traditional trading methods.
According to the list, hedge funds that solely focus on Algo-trading enjoyed massive returns last year compared to those who had partial involvement. A case in point is Leman Capital Management a quant-focused asset management firm based in the UK.
Leman Capital was ranked amongst the top performing algo-trading firms for the year 2015, after managing a return of 62%. The firm outperformed 99% of the Algo-trading firms for the third year in a row and according to recent results, it is on course to improve upon last year’s performance.
Leman Capital Management reported 34% return for the first six months of 2016. The firm is also outperforming last year’s monthly performances after averaging 5.8% return per month compared to 5.2% monthly return in 2015.
So How are Quant Investors Managing to Beat the Rest of the Market?
With fundamentals-based investing, nearly 80% of trading is now done via high-frequency trading platforms. The shift towards automated trading comes with several benefits.
First, with automated trading, investors eliminate the risk associated with emotional trading. According to research, most investors and traders fail because of panic buying and selling. However, with automated trading, every trading decision is made in advance.
Algo-trading systems rely on various technical tools, with rules and instructions encoded in their algorithms. This means that regardless of what the general view of the market is, the system picks trades based on a select set of technical tools, rules and instructions. These tools are developed in such a way that they are able to identify trends, market volatility levels, as well as key buying and selling scenarios, among others.
Since the SEC (Securities Exchange Commission) passed the rule to develop the first HFT system in 1998, the speed at which trades are executed has been cut down to less than a microsecond. The first HFT system was developed in 1999 and in the early 2000s, trades were being executed in just a few seconds. In the early 2010s, traders were executing trades in milliseconds and today, reports indicate that deals are executed within a hundredth of a microsecond.
High-frequency trading was once limited to large corporations, which had the resources to invest in such systems. However, due to technological advances, individual traders can now access such services at more affordable budgets than before.
This form of trading was also once linked with the younger generation, but over the last few years, millennials have adopted modern techniques of trading to leverage their investments in long positions.
Conclusion
In summary, algorithmic trading is now readily accessible via various trading platforms. Traders can now code their own rules and instructions in combination with a set of trading indicators to come up with automated trading systems.
However, institutional investors and dealers still have the advantage, especially when it comes to equities trading, because they are the ones who have access to the so-called “dark pools”, and in using their algo-trading systems, they are able to access more markets and trading assets than the ordinary investor.
The bottom line is quant trading has taken Wall Street by storm, and while there are a few who still believe that it should attract more regulation, many are beginning to embrace it as they seek better returns, even during extremely volatile market conditions as seen over the past several years.
Disclosure: I have no position in any stocks or commodities mentioned in this article.
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