Propeller-Head Ubiquity, Part 1: The Next Generation of Quantitative Trading
Paul Rowady, TABB Group 20 June 2014 Traditional, high-turnover quant equity strategies are saturated. As competition has heated up and the arms race of latency-sensitive infrastructure relative to the perceived theoretical alpha has shifted, quant firms have been seeking new sources of performance. TABB Group has been closely studying and commenting on the evolution of quantitative trading for many years. And though the fruits of quantitative research methods have permeated a vast spectrum of trading strategies within the past several years, high-turnover versions of quant strategies traditionally attracted the most attention. They still do. This is primarily because of their awe-inspiring departure from anything related to human-scale methods as well as tales and growing evidence of their staggering risk-adjusted returns (and absolute profits). Paradoxically, extreme success always defies attempts to remain hidden, providing attractive scaffolding for pundits, media and students of the markets on which to build their narratives. In June 2011, TABB Group published Quantitative Research: The World After High-Speed Saturation. (Ed. Note: TABB also produced related videos as well they can be found here and here.) Our hypothesis at that time was that the latency arms race would result in fewer players capturing more theoretical capacity in core markets, asset classes and products a phenomenon we called the tip of the spear thereby forcing all high- speed quant players (that were committed to remaining in the game) into new or additional regions, asset classes, products, and/or slower turnover frequencies. In other words, ultrahigh-speed trading in US equities had become saturated around that time, and that players would need to diversify. Heres an excerpt: If last years [2010] Securities Industry and Financial Markets Association (SIFMA) technology conference was any indication, the saturation of latency eradication systems was palpable, indicative of the changes we face today. A handful of firmswearing both sell-side and prop jerseysare successfully defending the limited capacity in high-frequency and micro-market structure arbitrage strategies in the US. With the prohibitive costs of incremental speed and dwindling volumes, punctuated by regulatory zeal, the average quant team must face up to the inevitable: change or die. Alpha is elusive, ephemeral and enigmatic. There is no guarantee of persistence. For many of the players, the required measure of change will be too much to handle. Over the past year, two prominent option-focused prop shops have yielded to the superior speed and prowess of their competitors and taken their balls home. In one of these cases, you couldnt possibly have thrown more bleeding-edge, out-of-this-world low-latency technology at the problem. The impediments were beyond hardware, but more likely related to a lack of quantitative creativity. Undoubtedly, others will follow. For those willing to brave the journey ahead, there are plenty of juicy opportunities to explore, some of which will certainly surpass the capacity and profit potential of current microstructure arbitrage trades. But hunting for new sources of alpha requires new gear. Surrounding and feeding this new gear is a requirement for new skills. Quants need to cultivate a new zest for solving even messier data challenges; they also need to develop a passion for the financial equivalent of a deep anthropological dig. The need for speed will never end. Only the disproportionate focus of the recent past will be reallocated. Cross-asset, cross-regional, multi-temporal, asymmetric versus symmetric trades, and even enhanced front-to-back automation will all benefit from this reallocation. Welcome to the age of multidimensional arbitrage. In March 2014, we conducted a survey to help update our understanding of the pulse of the quantitative trading landscape. Based on our understanding of quantitative history and coupled with these latest survey results, TABB Group is updating its vision and hypothesis for the quant landscape: First, saturation has spread beyond US equities into other regions, products and asset classes. Today, fewer players are capturing more of the available theoretical capacity for global high-speed alpha. Second, the future for quantitative methods has never been brighter. Our multi-dimensional alpha concept is still intact. But the bridge from here to there will require new skills and the digestion of a lot more data. Quantitative methods will permeate more of the traditional investment strategy spectrum to the point of propeller head ubiquity. Oddly enough, ubiquity will serve to shroud quants in a cloak of invisibility. Automated methods will become indistinguishable from everything else. The only question now, is: On what timeline? Although the metaphor might not be entirely accurate, we cant help but think of the Roadrunner and Wile E. Coyote with the quants starring as the Roadrunner and the rest of us observers for better or worse as Wile E. Since mid-2011, the lather over high-frequency trading (HFT) has only grown, especially recently with the publication of Michael Lewiss Flash Boys. Beyond the ebbs and flows of the media circus, however, there are many more tangible clues that have added up over the interim period that have provided rare glimpses into the revenue breakdowns of leading proprietary quant shops and that further serve to support or alter our original hypotheses: that those firms engaged in the highest-turnover strategies, and primarily those focused on US equities, would need to look elsewhere; to focus in other regions, asset classes, and products and, ultimately across all of these, including slower turnover frequencies. We have called that new era, multi- dimensional alpha Since mid-2011, the regulators, too, seem to be more on their game when it comes to high-speed trading in comparison to many other topics. The January 2013 rollout of the Market Information Data and Analytics System (MIDAS) by the US Securities and Exchange Commission (SEC) is quintessentially indicative of the idea that Wile E. may finally be gaining ground on the Roadrunner (see Exhibit 1). Exhibit 1: MIDAS - Order Book Reconstruction Visualization Tool
Source: Securities and Exchange Commission Unlike in the cartoons, however, TABB Group believes that Wile E. does periodically catch up to the Roadrunner that the observers and analysts can eventually attain enough insight into how certain microstructure arbitrage strategies work. That part is really the story of alpha decay and natural information leakage and why purveyors of these strategies need a continuous flow of new ideas. Because of this dynamic, our original prediction on the growth of multidimensional trading was right, at least in part. Are we at the end of the high-speed arms race? Could we have finally reached the theoretical capacity at the tip of the spear? Could there be only one firm capturing all of it? And if so, whats next? 2014 Quant Survey TABB Groups March 2014 survey of market participants targeted mainly quants, but generally any informed observer of the evolution of quantitative trading strategies. Exhibit 2, below, is a breakdown of firm types from the survey. Exhibit 2: Survey Methodology Breakdown of Firm Types (N = 51)
Source: TABB Group However, before we dive in to the newest clues of the evolution of quantitative trading, it would make sense to showcase the prism through which we are observing this landscape. It turns out that, though broad in terms of the possibilities, the scope of those possibilities is finite. Most quant strategy discovery begins with identifying sources of theoretical capacity. Quantitative Theoretical Capacity Framework At its base, this story is about automating that which formerly has been done manually. First, tasks in a workflow become automated, and then significant components if not, the entirety of the workflow become automated. Following full workflow automation is refinement, optimization, and higher-performance automation. In some product classes, we are clearly at the stage of highest performance automation; and where microscopic shifts in market structure implementations can open and close arbitrage opportunities in an instant. Where do quants look for alpha? The optimal target must exhibit a convergence of factors, but generally comes down to two: liquidity and level of automation. (A third factor complexity makes the scenario even more ideal, but we will get to that later.) Those products that are liquid and highly automated represent a breeding ground for high Sharpe Ratio (SR) strategies. This means that smaller players can leverage a small amount of capital for high returns with low risks (see Exhibit 3). Exhibit 3: Quantitative Strategy Framework
Source: TABB Group The fact that quant equity strategies can have little or no exposure at the end of a day makes all the difference in the world; since holding positions overnight creates margin requirements and an exceedingly more complex level of portfolio construction, going home flat is a huge deal. But as competition has heated up and the arms race of latency-sensitive infrastructure relative to the perceived theoretical alpha has shifted, quant firms have been seeking new sources of performance. This means migrating beyond the high-capacity/highest-Sharpe Ratio products (blue zone, above) closer to the fringes of capacity and SR (green zone, above). Generally, this means new regions, products and asset classes. This was the claim we made in mid-2011 and more specifically in mid-2013 that quant firms would need to look in new product classes, asset classes, and regions. Turns out the Roadrunner was already a few steps ahead of us. In the next installment in this series, we showcase and respond to the findings of the March 2014 quant survey. In Part 3, we highlight publically available data from two leading high-speed trading firms that ultimately complement the survey findings. And Part 4 summarizes TABB Groups latest views on quantitative trading and methods.
2009-2014 by The TABB Group, LLC and contributors | info@tabbgroup.com | +1-646-722-7800 Print
Propeller-Head Ubiquity, Part 2: Special Sauce and High- Turnover Diversification Paul Rowady, TABB Group 27 June 2014 As quant firms have been forced to expand the search for theoretical alpha to new asset classes, regions and products, the ingredients of their special sauce may be shifting too. And the search may be getting harder and harder. This is Part 2 of a 4-part series on the next generation of quantitative trading. View Part 1. The components of competitive advantage or special sauce, in the vernacular for quantitative trading firms are among the most intensely discussed and often misunderstood topics on the global markets landscape. To better understand these competitive ingredients, TABB Group conducted a survey in March 2014. Our line of questioning divided the sources of competitive advantage framework into four components: human capital, software and processing, data, and hardware and infrastructure. When asked to rank these components, survey participants were clear in their opinions overall. Human capital translated by TABB as developer, analytical and management skills is the most important ingredient for special sauce in quantitative trading/methods; and, surprisingly, hardware and infrastructure the stuff that is perceived to deliver the speed was ranked last. Software and processing vs. data as competitive components were ranked almost evenly (see Exhibit 1). Exhibit 1: All Survey Participants - Sources of Competitive Advantage (n=27)
Source: TABB Group These rankings were different from what we expected. However, looking more deeply into the results, proprietary trading firms expressed differing opinions from the broader sample and ones more in-line with our original expectations (see Exhibit 2). Exhibit 2: Proprietary Trading Firms - Sources of Competitive Advantage (n=14)
Source: TABB Group When these results are taken in conjunction with the results from the expected change (1-2 years from now) in sources of competitive advantage (see Exhibit 3, below) and overlaid with our experience with quantitative trading strategies, we reach the following conclusions: Hardware: Hardware and infrastructure is a declining source of competitive advantage for a vast majority of quant players. TABB Group has been calling this the democratization of infrastructure for the past year or more. Going forward, quantitative firms will 1) off-load more of their infrastructure needs, and 2) simultaneously migrate more infrastructure to one focused more on computational engines able to execute more complex calculations at much higher speeds than today. Human Capital: TABB believes that human capital should always be ranked highest relative to the other components of competitive advantage, independent of trading strategy or stage of workflow. Human capital is the one source of special sauce that is least susceptible to democratization. This is where we found the strongest shift in opinions in the survey data. Furthermore, TABB believes that certain players high ranking of hardware and infrastructure is actually a misinterpretation of the value of their human capital. With proprietary infrastructure remaining a key competitive advantage by a declining list of firms, persistence of this special sauce can only happen by virtue of the skills and creativity of their employees. Data: Though we might have expected a different outcome from these results, it is true that data or at least, raw market data is the most democratized of the four components in our framework. For certain asset classes and products in the most developed regions, both historical and real-time market data is incredibly clean. Scrubbing unclean market data used to be a competitive advantage. Now it is not. Along the road ahead, new strategies will require a mix of new and different data sources. Exhibit 3: All Survey Participants Expected Change in Sources of Competitive Advantage (n=27)
Source: TABB Group Low-Hanging Fruit TABB Group has been monitoring closely the diversification of high-turnover and the broader spectrum of quantitative trading strategies for many years. Our claim in 2011 that ultrahigh-speed trading in US equities was saturated is further borne out in our most recent findings. The difference between 2011 and now, however, is this: While US equities were saturated where leading quant firms were often consuming the alpha of other slightly slower quant firms other regions, asset classes and products were not nearly as saturated. The question now is whether any of these lower-hanging opportunities still exists within the scope of ultrahigh-turnover strategies. Or has saturation proliferated into other assets, products and regions? The answer to these questions will have a strong impact on the next generation of quantitative research and the development of new automated trading strategies. Asset Class Diversification Survey participants rankings of current and future comparisons by asset class support TABB Group assertions that there continues to be a need for diversification into additional asset classes, particularly fixed income (see Exhibit 4). Exhibit 4: Quantitative Strategy Rankings Current and Future Comparison by Asset Class
Source: TABB Group Our survey finds clear expectations for increased focus on FX and fixed income, which have the greatest potential (comparative theoretical capacity to equities notwithstanding) among all asset classes. However, in the case of fixed income, we are concerned that the pace of transformation to more automated trade workflows is slower than expected or desired. The pace of adoption of electronic execution of a broad spectrum of fixed income products (cash and derivatives) may not supply enough opportunities when compared to the demand for new high-turnover strategies. Product Class Diversification Product class diversification is primarily focused on cash, futures and single-stock options, where cash represents cash equities and equivalents, like exchange-traded funds (ETFs) and exchange-traded products (ETPs), but does not include cash bonds and is presumed not to include spot FX (even though technically it is the ultimate cash product) and where futures represent multi-asset exposures. Since options on futures typically have low liquidity, the options category here relates primarily, if not totally, to single-stock options (see Exhibit 5, below). As with expected asset class diversification (above), survey participants also expect the focus on the more mature products in quant strategies to decline, although for different reasons. The issues in cash equities are well noted herein. Newer products, such as swap futures, are worthy of experimentation across the expanded spectrum of rates products, but their current low level of liquidity and concentrated adoption may not justify the investment right now. Cleared swaps are similar in terms of potential for experimentation, but the timing might not yet be good and the average trade sizes are still way too large for most quant shops. The one exception in core cash equity strategies has been the intense interest in and addition of ETFs and ETPs, which have highly similar characteristics to equities with the added potential for index arbitrage-like overlays. Exhibit 5: Quantitative Strategy Rankings: Current and Future Comparison by Product Class
Source: TABB Group Single-stock options markets are not only fiercely competitive with a number of seasoned incumbents; they also represent uniquely complex computational challenges. As a result, it will be fascinating to see how well high-frequency quant firms born in the equities arena enter and grow in the options arena. Other than fixed income, options also may offer compelling potential, but they represent markets that are very difficult in which to compete and harvest alpha. TABB Group believes that this is a space that could see some (M&A) transactions. So far, leading equity- centric HFT quants have been able to migrate smoothly into futures products, competing well with futures- centric firms such as Infinium Capital, Jump Trading, and Chopper without the need to partner. It remains to be seen whether the same dynamic will play out in options. Maybe this is what Virtu is really after with its IPO a better currency for transactions. That said, the jury is still out on how well New York-Chicago mergers actually work in practice. Regional Diversification Regional diversification is a classic move to extend the theoretical capacity of core alpha. The original options market-making powerhouses of the 1970s and 1980s, inclduing OConnor & Associates, first took their special sauce from Chicago to New York, Philadelphia and San Francisco. From there, they sought to OConnorize derivatives markets in London, Tokyo, Sydney and elsewhere. Its a fairly well-worn path. So, too, have noted quant firms especially high-turnover quant firms marched from Chicago, New York, Amsterdam and a few other locations to set up shop outside of their home turf. Though often proving successful in highly developed markets, liquidity, and therefore, theoretical capacity, falls off dramatically from there. So, while there are numerous other markets where core quant strategies will work well, the level of profitability may not justify the technology investment in the current environment. Survey responses suggest that there is movement of focus from developed markets to developing and emerging markets (see Exhibit 6). Exhibit 6: Quantitative Strategy Rankings: Current and Future Comparison by Region
Source: TABB Group As we look back across developments in asset classes, products and regions, we cant help but wonder if the saturation we saw in 2011 in US equities has spread across the full spectrum of high-turnover strategies. If high-turnover strategies for cash equities, futures and options in developed markets are pretty much at the point where leading HFT firms are consuming the alpha of other HFT firms, then that is likely a signal that the pure speed game is just about played out for new and most existing high-speed firms. High-Hanging Fruit Shifts in quantitative trading strategies can be detected by shifts in the types of data being consumed. The slower the turnover, the more other types and sources of data are required beyond tick-level market data. These sources can be broadly bucketed into categories such as market data, reference data, fundamental data, commentary (including traditional news, industry research, and social media), and the derived data or analytics that flow off the back of all that raw data. The ranking of data categories reflects the amalgamation of quantitative strategy needs (see Exhibit 7). Exhibit 7: Rank of Data Source Types (n=27)
Source: TABB Group These reactions are supported, in part, by additional findings from the survey. While there are still firms seeking more speed, the desire to slow things down is non-trivial. Nearly 20% of respondents claimed their average turnover frequency (TOF) was slowing. With this fact in mind, we would then expect portfolio construction to shift from more asymmetric where positions are independent to more symmetric which relies on portfolio construction, rebalancing and maintaining market neutralities since asymmetric strategies most often rely on speed. This is also evident in the findings, where symmetric strategies represented at least 29% of the responses (see Exhibit 8). Exhibits 8: Quantitative Strategies: Changes in Turnover Frequency and Portfolio Construction Changes in Turnover Frequency
Nature of Portfolio Construction
Source: TABB Group We confess that there are some notable flaws in these findings, as well which have more to do with survey construction. For instance, faster in the Changes in TOF chart above could mean several things, including slower strategies becoming faster, but not at the same scale as the micro-second crowd. Bottom line: It seems odd to say, but if the latest generation of high-turnover strategies represented the equivalent of low- hanging fruit, then the next generation of quant strategies will need to pick the fruit from much higher up in the proverbial tree.
2009-2014 by The TABB Group, LLC and contributors | info@tabbgroup.com | +1-646-722-7800 Print
Propeller Head Ubiquity, Part 3: A Rare Glimpse into Prop Tradings Strategies and Profitability Paul Rowady, TABB Group 08 July 2014 It is extremely rare for the public to get a glimpse into the profitability, revenue segmentation, or strategy breakdown of a proprietary trading firm. But in the past two years, the public has been gifted unprecedented transparency into two of the worlds foremost quantitative prop trading powerhouses: GETCO and Virtu. This is Part 3 of a 4-part series on the next generation of quantitative trading. View Parts 1 and 2 here. It is an extremely rare event when the public gets a glimpse into the profitability, revenue segmentation, or strategy breakdown of a proprietary trading firm. In recent memory, it is not since the attempted IPO of Chicago proprietary options trading firm Peak 6 in October 2001 that we have had such a look. However, in the past two years, the public has been gifted unprecedented transparency into two of the worlds foremost quantitative prop trading powerhouses: GETCO and Virtu the first as a result of GETCOs merger with Knight Capital, and the second as a result of Virtus ongoing IPO trajectory (which, as many know, has since been delayed). Both events and the associated filings gave us a taste of all three of the above: profitability, revenue segmentation, and high-level strategy breakdowns. Both the words and the numbers in these filings tell a story that TABB Group has been following for years. In the GETCO now KCG data (below), we can see how a high dependence on Americas trading (most likely focused on US equities market making) in the 2009 (and earlier) period led to regional diversification, mainly to Europe first and then Asia-Pacific (APAC), which in this case includes Singapore, Hong Kong, Japan, and Australia (see Exhibit 1, below). Exhibit 1. GETCO Form S-4 (12 Feb 2012): Trading Revenues (2007 Sep 2012, $millions)
Source: KCG, TABB Group TABB Group believes that it is further evident from this data that overall profitability was highly correlated to volatility first (2009-2011) and competition second (2012). With aggressive globally coordinated central bank interventionism strategies ramping up in the post-global-financial-crisis (GFC) period of late 2008 and early 2009, strategies that were dependent on (higher) volatility suffered as global markets became awash with volatility-crushing quantitative easing (QE). Note the positive impact on revenues in 2011, which TABB Group attributes to a correlation to the then-looming threat of a US default and the resulting spikes in volatility in the third quarter of that year. Furthermore, TABB believes that the nearly $300 million in revenue declines between the 9 months ending September 2011 and September 2012 were due to something more: competition. But we need not necessarily speculate on causes and changes in tactics. Notable highlights from the GETCO/KCG filing deliver the answers: Declines [in]revenues were impacted by lower overall market volumes, reduced levels of volatility, increased competition and a higher percentage of internalization in U.S. cash equity markets; and Headcount increases related to early investments in the Global Arbitrage, Mid-Frequency and Options trading businesses. And, Colocation and data line expenses increased to $81.4 million in 2011 from $55.2 million in 2010. The increase in colocation expense was primarily due to the build out of new colocations in Mahwah, New Jersey, Basildon, United Kingdom, and Tokyo, Japan, as well as higher vendor rates for data and services. Bottom line:TABB Group believes that the market ecosystem was no longer supporting the same level of theoretical capacity for all high-turnover participants, and the competition was becoming increasingly fierce. Finally, although the reasons may have had more to do with operational retrenchment in the wake of the GETCO-Knight merger in mid-2013 than the threat of competition, we note that the KCG annual report for 2013 shows non-US revenues declining dramatically, from 46.5% of total KCG revenues for 2011 (which is an almost exact regional split of the GETCO-only numbers) to 18.9% of total revenues for 2013. Whether for enhanced operational integrity or the threat of increasing competition or some combination of these and other factors, we believe that there was a retrenchment to the core regional strategy in 2013. But then, we turn to Virtu. The Virtu data, made public just this past March 2014, continues the narrative (see Exhibit 2, below). This is an example of a firm with a more diversified portfolio of strategies even if they are all variants of high-turnover, latency-sensitive strategies. Exhibit 2. Virtu S-1 (10 Mar 2014): Total Adjusted Net Trading Income (000s, USD)
Source: Virtu, TABB Group It is because of this diversification that revenues continued to increase for Virtu in the post-GFC period, particularly in the past three years when many high-frequency players were suffering declines, changing strategy mix, or exiting altogether. Interestingly, with declining rates of growth in its core Americas equities strategies and flat-ish growth in its global commodities futures strategies, Virtu continued to more than make up for lost ground due with success in areas such as FX, non-US equities, options and fixed income (see Exhibit 3, below). Exhibit 3. Virtu S-1 (10 Mar 2014): Total Adjusted Net Trading Income (000s, USD)
Source: Virtu, TABB Group With growing competition and strategy maturity in global equities and futures strategies, the target for further high-turnover strategy growth will need to be in fixed income, including the ongoing Dodd-Frank led transformation in the swaps market. (But will this be enough to overcome declines in other products, assets, and regions?) Also, bear in mind that this diversification is likely to be difficult in options strategies which primarily means single-stock options strategies. While Virtu may have discovered a unique and persistent speed advantage across products, regions, and asset classes (an incredible feat representing the pinnacle of what TABB Group believes is its core value proposition), it will be met with formidable competition in options, with firms such as Wolverine, Susquehanna, Ronin, IMC, Optiver and a few others. As a result of all this, TABB Group believes that the timing of Virtus filing is indicative, if not prophetic, of more persistent market shifts. Whether Virtu ever goes public (given the current delay), there is some rather stark writing on the wall: Chances are that the expected gains in high-turnover fixed income strategies will not make up for the stagnation or declines in just about everything else for the foreseeable future. Virtu has taken diversification in high-turnover (market-making) quant strategies to new levels. According to its recent S-1 filing, Virtu makes markets in more than 10,000 securities and other financial instruments on more than 210 unique exchanges, markets and liquidity pools in 30 countries around the world (see Exhibit 4, below). Chances are that this is the most comprehensive list of venues less the full list of specific dark pools where high-frequency trading is even possible on the face of the planet today. Exhibit 4. Virtu S-1 (10 Mar 2014): Liquidity Venues
Source: Virtu, TABB Group (** estimates)
2009-2014 by The TABB Group, LLC and contributors | info@tabbgroup.com | +1-646-722-7800
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