September 25th, 2007

TABB Group Says Nearly One-Fifth of All Algorithmic Flow is Being Sent through Customised Algorithms

Adam Sussman, senior research analyst at TABB Group: “...the current usage of various algorithms and DMA tools is not the ideal state for the buy side, but rather the optimal selection based on its current options.”

TABB Group estimates that before the end of 2008, at least 30% of all algo flow will be sent through these customised strategies—up from 18% today—as brokers continue to offer customisation to a broader set of clients.

According to Adam Sussman, senior research analyst at TABB Group and the author of a new research note, “The Modular Algorithm: The Growing Choice in Buy-side Execution Strategies,” the buy-side’s use of canned algorithms, pegged at 58% in 2005, will account for less than half of all algo flow by 2008 because “the current usage of various algorithms and DMA tools is not the ideal state for the buy side, but rather the optimal selection based on its current options.”

For algorithm providers, customisation further feeds the product pipeline for canned algorithms, re-engages buy-side clients on a personal level – something that had been lost as FIX replaced the phone and entertainment rules became more stringent – and differentiates brands on a crowded shelf of products.

“In the end, this is a buy-side issue because what traders really want,” Sussman adds, “is a tool that allows them to control an order using a wide range of variables, a tool that permits them to map the portfolio manager’s objectives into an executive strategy. This means an algorithm with a true sense of purpose. Instead of merely wanting all the data they look at incorporated into an algorithm, they want the algorithm to look and react to the data in a specific way.”

Another result of the growing choices among buy-side execution strategies is a steep decline in the amount of resources hedge funds are willing to spend building execution-only algorithms. “The bare minimum today to build an algorithmic infrastructure,” says Sussman, “is $1.3 million with recurring annual costs of $900,000 and personnel costs account for nearly half of that cost.” In 2005, he adds, there was little choice for a hedge fund to build its own algorithms but with customisation services and modular technologies, TABB Group believes that proprietary algorithmic usage will decline from 88% of all hedge fund algorithmic flow to 67% by 2008.

Citing examples, he explains that several quantitative hedge funds chose to split scheduling and routing responsibilities with the scheduling component kept in-house because deciding when to route is dependent upon proprietary data such as the expected alpha among a list of stocks. He adds, however, that these funds are outsourcing routing decisions to their brokers. Using this example, says Sussman, “The latest generation of algorithms automates this functionality through the use of a ‘would’ option that trades according to a participation strategy but would simultaneously hunt for additional liquidity among dark pools.”

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