Active money managers see an industry in turmoil. Active money managers face increased competition from passive products and index funds, which offer low fees combined with ever more complex ways of measuring the market. As the financial researcher Jim Bianco declared in Bloomberg Views earlier this year – “the active money manager model is no longer viable.” (The site’s editors were even more blunt. Arrive at that page through a search engine and the title is “Active Money Managers are Doomed.”)
I disagree, at least in the fixed income markets. There is an important role for active selection of investments in fixed income. To succeed, however, institutions large and small will need to upgrade their infrastructure to get a holistic, modern view of the market.
Finding grains of sand on a beach
What sets bond markets aside from their equity counterparts is the incredible diversity of products. Each company has dozens or hundreds of bonds with different coupons and duration. This means there are tens or hundreds of thousands of products for an individual trader to choose from. As regulation requires sell-side institutions to pull back from holding inventory, it becomes harder and harder for buy-side firms to find desired pieces of bonds.
Q2 hedge fund letters, conference, scoops etc
Compounding the problem was the piece-meal nature of the market. Traders at sell-side institutions relied on thick notebooks or complicated spreadsheets to track who held what and when. Electronification came to the market, but only partially. The most common bonds frequently trade online, but often in small amounts. Large portions of the market remain tied to voice trading. These bonds trade only a handful of times a year. Finding the right source can be like flying over a vast archipelago with a small turboprop plane – possible, but very unlikely.
A number of smart individuals and initiatives have sprung up to solve this problem and increase liquidity in the bond market. And to some extent they have been successful. Places like Tradeweb, Neptune and Trumid – along with the product I developed with the team at Algomi – Synchronicity – all have created marketplaces to support trading. Each one has its uses, but more than a decade after this conversation first started, the life for a trader has only gotten more complicated.
Bringing order to chaos
Today’s trader may no longer have to leaf through old pieces of paper, but they frequently have to flip between more than a dozen software systems, finding ways to locate liquidity without moving the market. It is a bewildering and expensive system, driving up costs and contributing to a system where it is harder for active managers to outperform their passive brethren.
This is why the next phase of market development needs to focus on synthesis. Rather than looking for a single platform that will achieve primacy in the market, we need to make it easier for different platforms to coexist. At its simplest iteration, I am talking about a liquidity aggregator, one that allows a single place for voice and electronic trades to live side by side.
These systems will be useful from day one, but the value proposition only rises from there. These unified systems will soak up massive amounts of data, finding patterns invisible to any one trader or system.
In an age when traders are required to perform increasingly in-depth post-trade reporting to confirm best execution, a unified system makes this transaction cost analysis easier. This can make trades more profitable and quicker while at the same time providing necessary regulatory documentation. Algorithms can be created to select the best venue, increasing the efficiency of the human trader and shaving precious basis points off execution. Aggregation allows traders to time opportunities, and make trades at times of maximum liquidity. This is a proven method that has worked for years in the equities and foreign exchange markets.
Both the buy-side and the sell-side will need to continue evolving to stay ahead of passive investment. I believe there is still a role for Active money managers to play, but in order for them to take advantage of the opportunity they need an infrastructure that allows them to do their jobs better.
Usman Khan is the CTO and co-founder of Algomi
