Michael Corcoran of ITG sits down with Jason Lapping, Head of Asia Pacific Trading for Dimensional Fund Advisors (DFA), to discuss the practical impact of electronic trading and dark aggregation on his trading process.
Jason Lapping, DFA: The primary driver for us using electronic trading is to give us full control over the trading outcomes. DFA’s unique process of generating investment returns is highly focused on the overall returns of an investment decision, and that includes the impact of trading. Portfolio managers generate orders for the trading desk but provide some flexibility over what to purchase on a specific day. This means we can be patient, exploiting the opportunities and liquidity available at any given moment. As a result, around 90% of our global trading volume is electronic. In Asia Pacific, that number is even higher, with over 95% of trading managed by our own traders using DMA and algorithms accessing both lit and dark liquidity simultaneously.
Dark and alternative sources of liquidity also form an important part of our strategy. DFA manages in excess of US $240bn, so we are often interested in trading a large percentage of a day’s volume in a stock. We utilize dark pools to try to achieve this in a way that does not signal to the market. Most of our dark pool fills are small, but cumulatively they amount to a significant extra size traded without signaling the extent of our interest to the market.
We generally trade in dark and lit simultaneously as there is an opportunity cost to placing an order only in the dark. So for us dark liquidity is particularly useful as a complementary strategy.
Firms often describe what they do as trading securities, but in fact what we are doing is trading liquidity. And anything that helps us interact with more liquidity is really important. Therefore in the developed Asia Pacific markets, about 10-15% of our total executions are done in dark pools. We believe this helps reduce implementation costs while getting more done. Both of these elements benefit our investors.
JL: Trading is very much a value-add in DFA’s overall investment process. So our engagement with clients involves explaining that we have an integrated investment process where portfolio managers work closely with the trading desks, giving them a degree of flexibility. When the market is not going our way, this flexibility allows DFA traders to be patient on a specific stock at a given point in time. When the market is going our way, it allows our traders to be opportunistic. We execute at prices where it makes sense to do so, not because we have been told to get the order done today.
What this ultimately means is that trading can start to add value, rather than being a drag on a portfolio’s returns. The cost of implementation can be significant, and our job as traders is to minimize the gap between the theoretical and actual returns of portfolios. I think that many of our clients find this is a differentiator for DFA, and it is potentially a reason to choose us over another investment manager.
MC: So how has this evolution of the trading desk at DFA been applied in practice?
JL: The key changes we have seen over the past five years for our own Asia trading process broadly fall into three areas:
• increased usage of algorithms and customized algorithms,
• using more dark pools, and
• dark pool aggregation.
As I mentioned earlier, in an attempt to retain control of the trades, we use many customized algorithms. So the brokers we deal with have strong abilities in this area. Algorithmic strategies are particularly useful because of the large number of securities we have to trade. They also are an essential tool for dealing with the differences across the various Asia Pacific markets.
Part of an algo’s job is to act as a translator between the nuances of the different markets: the trader knows what kind of outcome they would like from a trade, and they want a consistent outcome whatever market they are trading in. Traders do not want to have to manage all the microstructure issues manually. Having the algo deal with the various market idiosyncrasies behind the scenes allows traders to focus on the real value-add of the trade. At DFA we have worked with brokers to customize algos so that we have a uniform approach to trading and one that is globally consistent with our overall investment philosophy. Our PMs require consistent outcomes whatever the market, and our custom algos help us to deliver that.
We have also seen growth in the number of dark pools in the developed Asia Pacific markets, and the biggest benefit is the liquidity they bring. Our relationship with dark pools is very interactive. It is important for us to have dialogue with dark pool providers. We often act as a provider of liquidity, particularly in the small- and mid-cap space. So we want to build relationships whereby we bring value to the pool and they add value in our execution quality. This way we all benefit.
Dark aggregation is one of the tools we utilize primarily to keep our settlement costs down. This goes back to the point that our primary goal is to minimize implementation costs for our end clients as trading costs can be a significant drag on portfolio performance. So we look at all the costs involved, across the process.
Aggregation also brings efficiencies in terms of how the traders interact with the variety of dark sources, and it definitely helps to improve both trade performance and our use of time. If you are trading 300 stocks in Australia and trying to access multiple dark pools, it is very difficult to manage effectively unless you use some form of aggregation, particularly given the rising number of pools available.
MC: So if we turn our attention now to compare Asia with other regions, given that DFA runs a fairly global process do you see the same trading tools now available in the different regions, and are there still differences?
JL: If we compare Asia Pacific and Europe for example, Europe operates on a more pan-European basis so when tools are developed they tend to work across more markets automatically. In Asia, on the other hand, the wide range of rules and regulations across different markets means the technology has to work harder behind the scenes. However Europe has more lit venues and fragmentation has moved the liquidity around more than it has done in Asia Pacific, where there is usually still a primary exchange. This means that in Europe you need to use or develop far more sophisticated SOR techniques.
MC: And do you find there are specific challenges in dealing with this?
JL: DFA has invested heavily in its global trading team and systems, which allows us to focus on trading and execution quality. So for us, the complexity of market structure represents choice and opportunity, rather than simply a challenge. We are used to actively managing our trading and we can choose where and when we want to engage. This helps us maintain our flexibility.
Having a complex market structure means you have choices: if you have choices of venues, types of orders and order sizes, this allows you to be more sophisticated instead of having a one-size fits-all, one-venue structure. If it is a very uniform market and you are restricted, it is harder for a trading desk to differentiate itself and add value. Our use of sophisticated trading techniques gives us choices which means we can add more value to portfolios, and to our investors.
MC: So looking at the Asia Pacific markets and how they might change in the future, what do you see as the biggest hurdles or changes coming up?
JL: Lack of uniformity of regulations across the Asia Pacific markets is significant and it is not a problem that is going to go away. There is also a risk of over-regulation – I very much believe in an environment where competition among venues is a good thing. It generally allows for a reduction in trading costs.
One simple example is at the level of average bid-offer spreads. Some of the fixed tick sizes in Asia are a real problem in keeping costs high both for institutional trading and also for retail trading – which usually involves crossing the spread.
MC: And what about the discussion around regulation of dark pools which is very topical at the moment?
JL: Dark pools are a benefit to execution quality, particularly in helping institutions like DFA avoid information leakage. If maintaining price formation quality on the lit markets is the concern of regulators, then having a good process around post-trade transparency is far more important than focusing on restricting dark pool trading and trying to dictate a one-size-fits-all or ’lowest common denominator’ structure.
From DFA’s global trading experience, when there is no confidence in the lit market price, no-one will trade in the dark, therefore it becomes a self-regulating environment. Dark pool orders are generally ‘pegged’ to the Bid, Mid or Offer of the primary lit exchange or NBBO . So if too much liquidity migrates from the lit venues to the dark venues, the reliability of the lit venues’ prices used as a reference for the ‘pegged’ dark pool orders would lessen. Traders or SORs would then pull back from dark activity in that stock.
Asia Pacific has the benefit of hindsight, operating at a market level on an 18-month to two-year time lag compared to US and European markets where dark and lit venues have proliferated. I hope regulators in Asia Pacific can learn lessons that help create an infrastructure where institutions can transact in a cost-effective way, rather than a one-size-fits-all trading environment. One-size-fits-all only increases trading costs and is a drag on portfolio performance – ultimately this affects people’s retirement funds.