Six Ways Trade Ideas Are Changing Investor Strategies

Trade ideas are changing the way investors approach the market. Here are the six major ways the buy side uses trade ideas in their investment strategies.

By Timothy J. Murphy General Manager, Americas, youDevise Limited

Trade ideas have existed ever since the first equity sales person picked up a telephone to recommend a stock to a client.

A lot has changed since then.

Today, trade ideas have become a premier alpha generating tool for traditional long only investors, long-short equity hedge funds and quant funds.

The modern use of trade ideas started earlier this decade when the London-based Marshall Wace hedge fund complex began to track the performance of brokers’ ideas systematically. MW found that their ideas regularly outperformed the market, prompting the firm to develop a proprietary website for brokers to submit ideas. MW went on to establish a variety of trade idea-driven hedge funds, an investment approach that enabled it to become one of the best performing, largest commission-payers in Europe.

Nowadays, ideas are developed by more than 600 institutional brokerage firms and used by more than 200 asset managers. This includes most of the world’s largest buy and sell side firms around the world. Industry commissions from trade ideas exceed $500 million. The buy side is driving this growth as investors seek to capture the alpha that is being generated externally to their own research departments, to benchmark their internal analysts and benchmark their brokers, and to regain visibility on market sentiment that has become obscured by the fragmentation of market venues.

How It Works

Unlike traditional sell side research, ideas are developed by sell side trading desk specialists and sent to clients via proprietary and third party platforms, which are used by those clients to augment their investment process with filtered, sorted and relevant ideas. Typically, ideas are client specific, and suggest how much should be invested in what security, when it should be invested, as well as when to close out the position.

Many clients want idea “authors” to explain their rationale and input a number of parameters that facilitate the idea analysis. This includes direction (long or short - no research-style “holds”), style (growth, opportunistic, value, news/event), conviction, time horizon, amount to be invested, target price, price method (touch, close or VWAP), and stop loss percentage.

Investors also like ideas to be price and time stamped so real time performance can be tracked on a relative basis, and for brokers to close ideas when they have played out, in order to develop a record of the relative historical performance.

Most investors pay for ideas based on their “alpha generating” performance, i.e., how much they outperformed the most relative index. Hence, idea management systems are sometimes called “alpha capture systems.”

Trade Idea Investment Strategies

There are six major ways the buy side uses trade ideas in their investment strategies:

1. Make fundamental investment programs more efficient. Traditional managers and longer-term hedge fund investors frequently have broad remits which can make it difficult for them to track how all of the companies in their investible universe are performing. Trade idea systems enable these investors to identify external buy or sell recommendations with a credible investment thesis that match their investment strategy. Broker-generated ideas become an insightful time and resource saving method for discovering undervalued stocks. Of course even the best investment thesis has greater credibility when it has been developed by equity desks with a strong track record of high performance within the ideas system. The ideas system also helps investors identify individuals or firms with a positive track record in specific stocks, sectors, or markets.

2. Timing of investments and exits: looking at idea trends, or sentiment, for specific stocks, sectors or markets, thereby helping a portfolio manager to decide the optimum time to buy or sell a stock. The fragmentation of markets has made it much harder for individual portfolio managers to judge sentiment at stock, sector, and regional levels. This makes it difficult for investors to time entry and exits into the market. Trade idea systems provide a unique insight. For example, a Portfolio Manager (PM) may believe the time has come to wind down a long position in stock XYZ. By checking his trade idea management system, the PM finds that a growing number of brokers are recommending that investors short XYZ. Based on this knowledge, the PM rapidly confirms his exit strategy. Conversely, if the investor is considering the purchase of a stock, the idea management system will illustrate which brokers have a current interest and positive track record of entry and exit for the stock or sector, and can provide indicators as to whether this is the right moment to move into the asset. The portfolio manager can use the trade idea management system to locate brokers with knowledge of the stock, or to judge the current market sentiment for his or her purchase.

3. Managing existing broker relationships. Idea management systems are able to provide PMs with real-time, monthly and quarterly reports on the performance of their brokers’ ideas versus relative indexes and/or industry peers. This enables PMs to gauge which brokers are actually generating alpha and how much. In addition, this enables PMs to refine their broker list, or the types of ideas they are receiving, to ensure they are achieving maximum results for their commission dollars. In an increasing number of cases, major investors are allocating most or all of their commission dollars based on trade idea performance.

4. Sampling new brokerage firms without getting involved in a direct trading relationship. In a market that many investors regard as over-brokered, it can be a challenge for a buy side firm to add another sell side broker to its list. Trade idea systems make this task easier. If a brokerage firm is on the trade idea system, a PM can ask to sample the broker’s ideas for a period. If the PM finds value in the ideas, he or she can decide to take on the broker by establishing a trading relationship or agreeing to pay the broker for ideas through a Commission Sharing Arrangement (CSA). If the broker fails to perform, the investor has a quantitative reason for declining the broker’s services.

5. Direct trading strategies. A number of hedge funds use trade ideas from authors they trust to drive their trading strategies. Idea management systems help them to identify contributors with strong track records in relevant stocks. They can then trade the idea directly with the contributors, layering their own trading skills on top of the ideas they receive. Trade ideas systems gather the ideas into a single place, greatly expanding the range of ideas such traders are able to consider.

6. Quantitative programs that involve using a large volume of ideas from a wide variety of brokerage firms, and processing these ideas through their trading models. To develop the trading formulas, a fund can buy historical files of historical trade ideas from their brokers. The fund then applies the trading formulas they develop to a low latency XML feed of new ideas which is sent directly into their trading engines. Unlike other quant trading strategies, ideas represent the first structured method to incorporate near real-time fundamental and technical data, as well as the insight of highly experienced market participants. This enables algo and quant models to adjust automatically to changing market sentiment, which can break down traditional relationships between technical indicators. In general, these quant programs fall along three lines:

• Stock signal. The programs analyze the long or short increase or decrease in the quantity of new ideas on an individual stock and/or sector as a leading indicator for what is likely to happen to the stock.

• Analysis by Idea Author and/or Brokerage Firm. The programs look at new ideas from an individual author or his/her brokerage firm ideas versus the performance of previous ideas from that author/firm, weighting ideas from high-performing authors more strongly in asset allocation.

• Modifier for other algorithms. Regional, sector and stock trends are used as modifiers to pre-existing algorithms, improving the overall performance of the quant strategy.

Changing the Way the Buy and Sell Side Work

As a result, trade ideas are beginning to change the way both the buy and sell side work.

• A growing number of traditional and alternative investors now formally allocate capital to trade idea strategies based on research showing that ideas outperform relevant indexes and there are a statistically meaningful volume of ideas globally.

• Brokerage firms with formalized trade idea programs generate incremental commissions through the development of value added ideas. This is facilitated through the unbundling of commissions and the use of CSAs.

• Because trade ideas need to be formally closed, new appreciation is being recognized for the “sell call.” As one broker told us, “That’s where trade ideas really help my clients. It makes everybody more aware of when to take profits or cut losses.”

• For the first time, investment managers are evaluating the performance side by side of trade ideas from bulge bracket firms and smaller independents. As one broker said, “Now, it doesn’t matter how big you are, as long as you have the right ideas.”

• Buy side firms are using trade ideas to quantify the value brokers create objectively, increasing transparency, and providing a quantitative input to the sometimes subjective broker vote process.

Ultimately, trade ideas are helping portfolio managers manage their investments more efficiently. By distilling and capturing all that a sell side firm is saying about a stock, and ensuring brokers are sending only ideas that a PM can actually use, PMs are able to identify alpha generating ideas faster, working more closely with the brokers that generate them.