Innovation in Finance
April 11 – 12, 2002
Innovation and change are constant features of financial markets as new technology, changing investor needs, regulation, and other forces affect the way investing and trading are carried out. This fifteenth annual conference of the Financial Markets Research Center, supported by a special grant from the New York Stock Exchange, and held on April 11-12, 2002, dealt with two areas of innovation – innovation in investing and innovation in trading. On the investing side, conference participants examined alternative investment vehicles, namely hedge funds and managed funds. How has the hedge fund industry developed? What types of investing strategies do these funds employ? What has been their investment performance? How are managers compensated? On the trading side, conference participants discussed recent developments in equities markets and futures markets, including regulatory changes. What is the future of innovative trading systems? Of traditional exchanges? Can market quality be accurately measured? How has regulation affected the quality and functioning of equities markets? What will be the effect of the new regulatory framework for futures trading?
The Thursday sessions took place at the conference facilities of Center member, Caterpillar Financial Services, located next to the campus, and the Friday sessions took place at the Owen School. Jim English, Executive Vice President of CAT Financial, Bill Christie, Dean of the Owen School, and Hans Stoll, Center director, welcomed participants to the conference.
The focus of the Thursday sessions was on hedge funds and related investment vehicles. Rich Lindsey, President of Bear Stearns Securities Corporation, chaired the first session, “Characterizing Hedge Funds.” He noted that Bear Stearns served as prime broker to many hedge funds, an activity which involves custodial services, brokerage, and securities lending. He commented, as did later participants, on the growth in hedge funds and the brain drain of investment talent to the industry. Steve Lonsdorf, CEO of Van Hedge Fund Advisors, provided a comprehensive overview of the hedge fund industry. He estimated that 50% of hedge funds are domiciled abroad. He described the structure of most hedge funds as limited partnerships with a limited number of accredited investors and an investment manager who is generally paid a base fee plus an incentive fee of 20% of profits. He provided data on hedge fund performance based on the extensive data based maintained by Van Hedge Fund Advisers. Vikas Agarwal of Georgia State University presented the results of a study carried out with Narayan Naik of the London Business School, “Characterizing Systematic Risk of Hedge Funds with Buy-and-Hold and Option-Based Strategies,” in which they show that major hedge fund equity investing strategies have important option features. In evaluating hedge funds, the non-linear payoffs, characteristic of options, and the associated risks must be considered.
John Damgard, President of the Futures Industry Association, next chaired a panel, “Developments in Hedge Funds and Managed Funds.” Before introducing the four panelists, he commented on two recent developments – the regulatory approval of single stock futures and the coming of retail hedge funds. Jim Klingler, Senior Vice President of Eclipse Capital, spoke on the historical development of hedge funds, which he dated to the market neutral strategy adopted in 1949 by Robert Winslow Jones. Bill Spitz, Treasurer of Vanderbilt University, described the university’s investment strategy, and noted that 25% of the endowment is in hedge funds. Of this amount, about half is in actively managed low beta hedge funds and about half is in a variety of absolute return hedge funds that follow a market neutral strategy. While transparency of hedge funds has improved, risks remain. These include high leverage, high concentration, and illiquidity of hedge fund portfolios. Eric Noll, Associate Director of Susquehanna International Group (SIG), a large market making and proprietary trading firm, noted that his firm follows trading strategies – event arbitrage, convertible arbitrage, and other types of relative value trading – that are followed by hedge funds. Consequently, SIG believes it is well-positioned to provide trading and other services to hedge fund clients. Jack Gaine, President of the Managed Funds Association and a long-time observer of the Washington scene, commented on recent political developments, including the anti-money laundering requirement to determine the source of investment funds, the impact of Enron on the regulation of derivatives, the degree to which hedge funds are exempt from registration, and developments at the Commodities Futures Trading Commission.
After the lunch break, Philip McBride Johnson, of Skadden, Arps, Slate, Meagher and Flom, and former Chairman of the Commodity Futures Trading Commission, in an entertaining and informative talk, questioned the extent of de-regulation under the Commodity Futures Modernization Act of 2000 (CFMA). He argued that de-regulation has gone too far when major institutional investors, central to the functioning of financial markets, are exempt from regulation. He also expressed skepticism about the future success of recently approved single stock futures. Regulatory restriction on allowable margins, taxes, and the dual regulation (by the CFTC and SEC) of these instruments so hamstrings them that they stand no chance of success vis à vis other instruments, such as options, that can be used to achieve equivalent positions.
Jim Cochrane, Senior Vice President of the New York Stock Exchange, chaired a session on hedge fund risk and compensation. David Hsieh, of Duke University, presented the results of an empirical study (with William Fung), in which the investment styles of different fixed income funds are classified by important underlying strategies (directional versus non-directional and static versus dynamic). The classification provides useful information about the underlying sources of risk. Martin Gruber, of New York University, in a study done with Edwin Elton and Christopher Blake, examined the behavior of investment managers of the few registered mutual funds that permit incentive fees. Managers earning incentive fees have better stock selection ability and lower expense ratios than do other managers, however, they have beta coefficients that are less than their benchmark’s coefficient. Consequently they under-perform their benchmark. Because incentive fees have a floor and a cap, managers become more conservative after a period of good performance and increase risk after a period of poor performance. David Sweet, Quantitative Analyst for Thales Fund Management, described the leptokurtic distribution of daily returns of individual stocks and suggested a procedure of normalizing the distribution.
The first day of the conference concluded with a tongue-in-cheek in-class examination on the subject, “Enron and LTCM,” administered by David Modest, Managing Director of Morgan Stanley and former partner at Long Term Capital. Part I of the exam posed a variety of questions about Enron and LTCM. Part II of the exam followed the Jeopardy format in which the question appropriate for the answer must be provided.
Day two of the conference turned to issues of trading markets, market quality and trading strategy. Before introducing the two speakers, the chairman of the first session, Thomas Peterffy, Chairman and CEO of Interactive Brokers Group, stressed the rapid developments in technology that make possible speedy and low cost trading. Customers also have the facility to add their own front end trading engines for routing orders or automating trading rules. Paul Bennett, Chief Economist of the New York Stock Exchange, discussed several issues related to market quality. He summarized the trade management guidelines promulgated in February 2002 by the Association for Investment Management and Research (AIMR) that call for disclosure by brokerage firms of potential conflicts arising from payment for order flow, from new issues allocation, and from related practices. He discussed some difficulties with SEC Rule 11Ac1-5, which requires market centers to provide data on execution quality. In particular, he noted that the rule covers only 31% of NYSE volume, that measures of the effective spreads fail to distinguish trades greater than the quoted depth from trades less than the quoted depth, and that different processors report different summary measures of execution quality given the same underlying data. Simon Wu, Economist at the Nasdaq Stock Market, reported the results of a study of order routing and execution quality for orders of less than 2000 shares in 100 Nasdaq and 100 NYSE stocks. Order routing data are taken from the SEC Rule 11Ac1-6 reports of 9 discount brokers and 5 full service brokers. Execution quality, taken from SEC Rule 11Ac1-5, is reported for those market centers receiving order flow. Matt Gelber, Senior Vice President of Fidelity Capital Markets, noted that Rule 11Ac1-5 reports of execution quality are useful to him in meeting his responsibilities to route orders to the best market.
The final session of the conference on the topic, “Trading Strategies and Trading Venues,” was chaired by Ron Masulis, of the Owen School. Ian Domowitz, Managing Director at ITG Inc., noted that automation is likely to lead to disintermediation of trading in retail orders, which can be handled in an electronic book market. On the other hand, institutional trades will require re-intermediation by electronic intermediaries that can effectively manage the more complex trading needs of institutional clients. Kevin Cronin, Senior Vice President of AIM Capital Management responsible for all domestic equity trading, discussed the difficulties of trading large institutional positions and the need for institutions to take direct control of their orders. Modification of NYSE rules that limits direct contact between an institution and a floor broker would enable institutions to have greater control of the trading process. Joe Lombard, Executive Vice-President of Archipelago, discussed the growing importance of electronic communications networks (ECNs) and the contributions of ECNs to market liquidity. He compared trading volume of ARCA/Redi, Island and Instinet and examined the quality of ECN markets in exchange traded funds (ETFs).
Vikas Agarwal, Georgia State University
Clifford A. Ball, Owen School, Vanderbilt University
Paul B. Bennett, New York Stock Exchange
Marshall E. Blume, The Wharton School
Nicolas Bollen, Owen School, Vanderbilt University
Thomas A. Bond, Chicago Board Options Exchange
G. Geoffrey Booth, Michigan State University
Sharon Brown-Hruska, George Mason University
Anchada Charoenrook, Owen School, Vanderbilt University
William G. Christie, Dean, Owen School, Vanderbilt University
Paul Christopher, Eclipse Capital Management
James L. Cochrane, New York Stock Exchange
Kevin Cronin, AIM Capital Management
J. Dewey Daane, Owen School, Vanderbilt University
John M. Damgard, Futures Industry Association
Ian Domowitz, ITG Inc.
Greg Faulk, Belmont University
John G. Gaine, Managed Funds Association
Amar Gande, Owen School, Vanderbilt University
Michael Gaw, Securities & Exchange Commission
Matthew B.Gelber, Fidelity Investments
Susan Greenan, Archipelago
Martin J. Gruber, New York University
Jerry Harder, Owen School, Vanderbilt University
William Henderson, Owen School, Vanderbilt University
David A. Hsieh, Duke University
Vlad Ivanov, Owen School, Vanderbilt University
Robert H. Jennings, Indiana University
Steve Johansson, Owen School, Vanderbilt University
Philip McBride Johnson, Skadden, Arps, Slate, Meagher & Flom
Herb Kaufman, Arizona State University
T. E. (Rick) Kilcollin, Kilcollin Financial, LLC
James R. Klingler, Eclipse Capital Management, Inc.
Veronika Krepely, Owen School, Vanderbilt University
Gemma Lee, Owen School, Vanderbilt University
Xi Li, Owen School, Vanderbilt University
Richard R. Lindsey, Bear Stearns
James Lodas, Matlock Capital LLC
Joseph C. Lombard, Archipelago
Steven A. Lonsdorf, Van Hedge Fund Advisors International, Inc.
Frank Majors, Willis Asset Management
David H. Malmquist, Office of Thrift Supervision
Ronald W. Masulis, Owen School, Vanderbilt University
Beth Matter, Alumni Publications, Vanderbilt University
Jennifer B. McHugh, Securities & Exchange Commission
Edmond Melkomian, VIRTEX, Inc.
Raymond M. Melkomian, VIRTEX, Inc.
David M. Modest, Morgan Stanley
Rajarishi Nahata, Owen School, Vanderbilt University
Christine D. Niles, The Nasdaq Stock Market
Erik W. Noll, Susquehanna International Group, LLC
Thomas Peterffy, Interactive Brokers Group
James Pinney, LETCO Trading
Charu Raheja, Owen School, Vanderbilt University
Robert K. Rasmussen, Law School, Vanderbilt University
John Rea, Investment Company Institute
Peter Rousseau, Economics Department, Vanderbilt University
Glenn J. Satty
Christoph Schenzler, Owen School, Vanderbilt University
Christian Schlag, University of Frankfurt, & Owen School
Jamie Selway, Archipelago
Joe Smolira, Belmont University
John Skarha, The Hull Group
William T. Spitz, Vanderbilt University
Hans R. Stoll, Owen School, Vanderbilt University
Kenneth Sutrick, Murray State University
David Sweet, Thales Fund Management
Randall Thomas, Law School, Vanderbilt University
George P. Van, Van Hedge Fund Advisors International, Inc.
H. Martin Weingartner, Owen School, Vanderbilt University
Simon Wu, The Nasdaq Stock Market
Allan Young, Syracuse University