Mutual-fund and other asset managers trying to get the best price on a stock purchase or sale face a formidable challenge from fast-moving high-frequency traders — but managers are not defenseless.
To be sure, it’s difficult to execute large trades when HFTs deploy sophisticated pattern-recognition software in search of order-flow information that they can use to their advantage. When an asset manager unintentionally leaves footprints that tip its hand to these HFTs, the price is often impacted to the detriment of the asset manager.
So what can an asset manager do to prevent this from happening? By answering this question, we can help institutional investors improve their execution, reduce transaction costs, and ultimately deliver better investment returns.
In a recent study, my colleague and I looked into this issue. Our goal was to provide a realistic analysis of the strategic interaction between investors trading for fundamental reasons, such as pension funds, mutual funds, and hedge funds, and traders seeking to exploit leaked order-flow information, such as certain types of HFTs.
We find that asset managers have a powerful weapon against HFTs that exploit order flow information: Randomness.