Seeking Alpha
, Blockdesk (2,050 clicks)
ETF investing, CFA, portfolio strategy, long/short equity
Profile| Send Message|
( followers)  

It's their obscene profit advantage, called "Order Flow."

You're probably playing the investment game. They're playing the players, including you.

But you're a small frog; they are much more interested in the big croakers. Those are the big-money funds, the Mutual Funds, hedge funds, pension funds, endowments, trusts, and anything else that scoops up the available capital of folks who don't know (or don't want to know) how to really make it work for them.

Those big croakers are mostly pros as well. Many of them also play the players, including the market pros, the market-makers [MMs], and of course, you. If you or your friends give them money to manage, remember what you heard back there in the "cheap(?)" seats on the plane: "When the oxygen masks come down, be sure to put yours on before attempting to help others."

The big croakers up there in first-class take that advice to heart in their business policy.

They're not dishonest, just astute business managers. But that puts you (and their customers) in at least 3rd place in the pecking order of the Investment Markets Game.

The investment markets, most of the time, are driven by so much advancing-knowledge-driven productivity from today's civilized world that there are plenty of crumbs falling off the table to keep poorly-informed folks with more income than they know what to do with (constructively), satisfied. If you're one of those, better find something more entertaining to read or pass the time with, because the rest of this article may be disturbing to you.

What's this "obscene profit" advantage?

Back to that thing called "order flow." It's not about your round-lot (or almost-round-lot) order tickets. The orders in the flow of interest to them are the volume ones, in tens and hundreds of thousand shares, even occasionally millions of shares, called blocks. It's the scale that the big croakers have to operate on, with their tens and hundreds of Billions of dollars under management.

Many big-fund holdings are in stocks that, at the level of the market's average daily trading volume would take weeks or months to exit from, and then to reinvest. Guess which way prices would move if they tried to do it that way.

So they try to split up their portfolio adjustment actions into smaller increments, and spread them around, into off-market "dark pools," into private deal arrangements with other croakers, and into anonymous offerings by MMs via the MMs' block trade desks.

That's where "order flow" intelligences come from. The market-making community has informal club rules that require keeping the trade order originator's identity secret, along with the precise size of his order, and a sense of its urgency of completion. But within the community of MMs, everyone knows who owns how much of everything that is either "in play" or likely to get that way. Big orders tend to get pretty well known and defined. The game gets very sophisticated as a result. High-fee investment information services have good businesses keeping on top of this shifting ownership scene and servicing their MM clients with updates.

The MMs have to try to keep a step ahead of their croaker clients, who in turn, have an obligation to their capital-investing clients to quickly get them out of situations turning sour. Even if it means "bagging" the MM at a high price before the MM learns what the fund has found out, by whatever means (in either case).

It may all look so simple, coming off a Bloomberg quote terminal. But the very serious game going on behind that screen can (and does) often make millions of dollars a minute in the pockets of MMs or croakers and their clients. Price-percentage wise, it can make similar differences to your involved capital, as an "innocent" bystander.

What difference might it make to you to know what the MM's know? Here's a quick, general, measure of that. We'll take a look at the difference between MM evaluations of the S&P500's near-term price-change outlooks, and those dominated by the actions of the public. We can do that because the MM community tends to hedge their bets directly in the S&P500 index (SPX), while the public tends to focus on the index intermediary, the S&P500 SPDR ETF (NYSEARCA:SPY).

Both SPX and SPY are involved with hedging activities to counter adverse potential market moves in the near future (certainly the horizon for MMs). It may be longer for the public, but we will look at the near-future of the next nearly 4 months - 16 weeks for the sake of comparability (SPY vs. SPX), and in recognition of its repeatability. The analysis evaluates what must be the coming-price expectations for the underlying securities in each case, or else the prices present in the insurance market (listed options) would not be what they are.

SPY tracks the SPX very closely, thanks to the arbitrage seagulls avidly patrolling that beach; "mine, mine, mine." So forget the idea of tracking errors as explaining any differences we see.

What matters about these expectations is the balance between their upside potential and their downside prospect. That is the real risk vs. return contemplation, measured directly in price-change terms. Our analysis produces this in its every-day application, by seeing where the MMs find it worth spending part of what could be a trade spread profit on price-change insurance to offset the chance of a resulting loss. Knowing where that matters to them provides a common-denominator means of comparison between investment securities, even those of widely different natures.

The reason this matters is because subsequent prices of most issues move quite differently, depending upon the balance between upside and downside expectations. That makes it important to have a clear measure of what the balance is for each security. We set up a measure that looks at the full range of prices being regarded as likely to happen.

The top of that range we regard as an index value of 100, and the bottom as zero. The current market price is usually (but not necessarily) somewhere in between. Its location is called the Range Index [RI], and its number is actually that percentage of the forecast range that lies to the downside.

So we are going to look at the hedging-based forecasts each day for the past 4 ½ years for both the SPX index and the SPY ETF, to see how their prices in the following ~4 months changed at various levels of Range Index. But before we look to the price changes, we need to right away be aware of a basic difference in MM perceptions of the two underliers, the SPX index, and the SPY ETF. The Range Indexes are characteristically shaped around different medians and have somewhat different-shaped distributions. Here are their cumulative occurrence frequencies, by actual count during the past 4+ years.

(click to enlarge)

We believe that these differences in expectations exist partly due to a shorter time horizon for the index hedges motivated internally by the MM firm's own strategic capital risk management, compared to those hedges on the ETF motivated by market-making demands by clients that require hedging of firm capital put at risk while making markets.

Since the public rarely is aware of the ability to traffic in index securities directly, and is very aware of the availability and advantages of ETFs, the dominant focus in that hedging arena tends to be driven by a "buy-side of the street" orientation and concerns. The above picture shows that the ETF Range Index distribution has a median value of 42, while the S&P500 index distribution's median is only 28.

That means that the public regularly has more downside concern than does the MM community. Shorter time of exposure for MMs = less opportunity for trouble? Perhaps. Also less opportunity for trend gains. But that long upside tail of their distribution reaches out to cover those possibilities as well, just less frequently than for the SPY, until Range Indexes get up into the 60s.

And there may be other reasons for stronger MM confidence and less downside concern, like continuing knowledge of the order flow.

But what matters, to both MMs and investors alike, is how prices behave in the weeks and months following forecasts at various RI levels. Here is that past record over the 2 same period as the distribution picture above. First for SPY, and then for SPX.

The following tables need some understanding. Their data columns are measures of price change, starting from the date of each forecast day to the number of market days shown in yellow at the bottom of the table. The forecast days include all market days during the last 4+ years, so there can be no time-period start-date "cherry-picking." By showing progressively longer time periods (weekly), end-date favorable engineering is minimized, while offering guidance as to desirable holding period tendencies.

The rows of the tables contain results for Range Index level experiences. They start at the top and bottom extremes and cumulate the number of experiences progressively until they meet at the mid-level blue row, which contains all experiences, so it is the population average. Grouping them this way aids in setting policy choices as to how extreme a Range Index may be needed to support an investment action decision.

The #Buys column tells how many observations are averaged in each row.

(click to enlarge)

(click to enlarge)

Please note that the blue-line averages for the two tables show identical price change histories. What is strikingly different is two-fold: 1) the distribution frequency of Range Index (R.I.) observations in the #BUY columns, and 2) the size of the subsequent price changes for identical RI cutoff levels between the two tables.

The appearance of far bigger payoff potentials at RIs under 30 for SPY than for SPX is severely muted by the number of such opportunities indicated in the top line of each table, 14 (of 1129) for SPY, and 603 (of the same-dated 1129) for SPX. The magenta numbers indicate current-day RI levels.

A quick look back at the frequency distribution comparison picture shown earlier helps to explain the striking differences here at the extreme. SPY now is at a RI of 37, and SPX at 13. The more precise focus of the MMs helps them be more cost-effective in hedging the S&P500 index, compared to a less-certain view of what could happen to the price of a looser-disciplined SPY price, as driven by momentary buy-side emotions.

Since the index and the ETF track closely, what actually is likely to happen has to be very similar, but the prices paid to participate in it may differ considerably, much to the advantage of the MMs.

This illustration of MM advantages is genuine, although perhaps unique in that there is a clear direct comparison available between perceptions of the two identities. The same kind of difference exists pretty much across the board in nearly all actively-traded stocks and ETFs, particularly where there is a strong institutional investor presence. Their "order flow" grants the MMs an enviable special license, earned by their skills and diligence in maintaining a currently more accurate perspective of future probabilities.

Source: What The Market Pros Know That You Don't