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Hedge funds driving up market volatility but thats OK, traders say

Date: Monday, May 5, 2008
Author: Isabelle Clary, Pension & Investments

Group urges SEC to end best price rule, tackle market data.

Hedge funds, powered by an increasing amount of capital that pension funds and other institutions pour into them, are playing a major role in the unusually high market volatility seen in recent months, according to the Security Traders Association, New York.

In a special report released April 30 titled “The STA’s Perspective on U.S. Market Structure,” the non-profit industry group tied the surge in volatility to the trading behavior of an estimated 9,000 hedge funds, which focus on short-term opportunities and involve complex multiasset strategies.

“(This) in itself creates movement and momentum among stocks that fuels volatility and velocity,” the report said, while noting that “public and private pension funds, endowments and other institutional investors have increasingly made investments in hedge funds, private equity and other private pools of capital as a way to diversify and achieve non-correlated returns.”

The report, which resulted from the STA’s annual review of market structure, recommended that regulators alleviate some regulatory burdens that play a role in securities markets, mainly by rescinding the order protection rule, familiarly known as the best-price rule, which is part of Regulation NMS, the 2005 set of rules the Securities and Exchange Commission adopted that were designed to modernize regulations governing the national market system.

Another culprit driving volatility that the STA report identified is the “significant increase in the number and impact of 130/30 funds,” used by both traditional and hedge fund managers to enhance returns because they too involve “investment and trading strategies aimed at short-term performance.”

Because they involve shorting up to 30% of the poor-performing stocks in a portfolio and add weight to the best performers, 130/30 strategies may typically require quick portfolio adjustments in active markets.

Other factors the STA cited for the jump in volatility to its highest since the bursting of the Nasdaq bubble include: the broad repricing of debt-related assets, “which cost investment banks and other financial firms billions of dollars in write-downs;” trading technology advances, which allow participants to get in and out of the market thousands of times a day at lightning speed; regulatory changes such as the Regulation NMS; and the new short-sale rule that allows investors to short a stock when its price goes down, which some say bears the risk of inviting stock price manipulation.

“The STA urges the Securities and Exchange Commission to aggressively pursue those who would manipulate the market,” the STA report said.

Overall, the report’s authors did not see the current high market volatility necessarily as a negative development — just one that bears watching and adapting to. One common measure of market volatility, the Chicago Board Options Exchange Volatility Index, or Vix, nearly tripled to a 52-week high of 37.57 on Jan. 22 from 12.43, its 52-week low reached on June 1, 2007. Since 1990, the Vix has averaged just over 19.

“Current volatility is not unprecedented, the speed with which markets move today is,” the report said. “For investors with short time horizons, volatility presents opportunities for performance returns. Long-term investors can wait out any fluctuations, as even volatile markets have risen over time.”

Changing markets

New technologies and the emergence of new market participants such as computer-reliant, high-frequency traders, have brought fundamental changes that warrant more attention from regulators because they have transformed markets, the STA report also found.

“Algorithmic and quantitative trading models continue to increase market share,” the report said, citing estimates that quant trading is reaching up to 50% of daily trading volume in some stocks and 22% of daily volume overall because it addresses market fragmentation by seeking liquidity in multiple places.

“This results in many clients using the same algorithms to execute orders in the same stocks. Most of the current genre of algorithms is reactive in nature,” the STA report found. “If multiple participants use the same algorithmic trading strategies, particularly in a low volume security, the result can create a short-term price dislocation.”

The STA expressed concern about quantitative models designed to pocket fee and market data rebates for high-frequency traders.

“There is no investment intent here … These models, particularly if they are based on similar strategies, may distort the market,” the STA report said, urging the SEC to align the various market data payment systems offered by different trading venues.

Another recent challenge for asset managers who seek best execution is the proliferation of dark pools or venues that do not display the orders in their book. The cost of accessing dozens of stock-trading markets might affect order-routing models, complicating best execution.

As a result, the STA asked the SEC to closely monitor the aggregate and individual volumes of alternative liquidity pools in order to ensure adequate price discovery. “Any loss of transparency, the competitive hallmark of U.S. markets, is a concern,” the report said.

But beyond new technologies, the main change in today’s marketplace may be institutional investors’ behavior, which increasingly employs products — namely futures and options — not previously included in their strategies. This activity too has helped drive up volatility in the cash market, as well as volume, the STA noted.

“Investment banks, hedge funds and traditional institutional managers are increasingly using derivatives and options strategies,” the report said. “Derivatives are also employed because they provide greater leverage to the investor or manager, lowering the manager’s cost of capital and enhancing returns … Options volume is up, driving up hedging activity, which may in turn increase volume and volatility in the cash market.”

Contact Isabelle Clary at iclary@pionline.com