As highlighted on Finextra.com, Chris Skinner has written an informative commentary on developments in cross-asset trading and the search for liquidity. Entitled The Quest for Alpha, this article should be a must read for all capital markets and risk management professionals who are interested in the subjects of liquidity risk, electronic and algorithmic trading, hedge funds growth (and influence), and the on-going technology transformation in a trading world where nano-sconds matter.

Alpha is that part of investment return that an asset manager or hedge fund produces that is uncorrelated with general market returns (often referred to as Beta). High Alpha returns generally also very richly reward "long/short" investment professionals under incentive compensation schemes such as hedge fund "Two and Twenty" fees arrangements. Toomre Capital Markets LLC ("TCM") previously has written about True Alpha and Hedge Fund Beta in highlighting two excellent articles written by Clifford Asness. Mr. Asness is currently the managing principal of AQR Capital Management LLC and previously headed the group that started Goldman Sachs Asset Management ("GSAM") quantitative strategies and its Global Alpha hedge fund.

The author states, "Alpha is all about finding liquid markets to gain higher margins and increased returns. Liquid markets are becoming harder to find as technology opens access for all, and the search for alpha is all about the search for liquidity." TCM disagrees with this statement in part.

Alpha is really about identifying situations where securities, derivatives, options, rates, indices, or futures are somehow out of balance with other tradable instruments. The relatively cheaper instrument(s) is purchased and the relatively richer instrument(s) is sold short. As the number of hedge funds has boomed (and more traditional investment managers begun to offer "long/short" alternatives), profitable arbitrage strategies are pursued by many more managers. It is generally agreed that it currently is much harder to produce alpha returns than it was several years ago and what arbitrage opportunities do exist are much more fleeting. Hence, there is even more of a focus on automated quantitative strategies and market sectors with electronic trading opportunities.

Consider for a moment one investment strategy called "pairs trading". One might start by performing a quantitative analysis on the historic trading of various technology common stocks. From that analysis, it might be apparent that one should buy one stock (perhaps Microsoft) and sell some quantity of another (for example IBM) when certain conditions are met. These "certain conditions" are the "secret sauce" about which hedge funds are so guarded and private. If the quantitative analysis produces a positive result within some acceptable confidence interval (after all almost all investment activities involve some degree of risk, however minute they might be), a trading strategy is coded up. This strategy is then submitted to trading area where the conditions are constantly monitored and trade instructions are issued if the strategy conditions are met. This trading area can be a human- staffed trading desk or more frequently, especially in United States equity securities, an entirely electronic system with human monitors.

Some of the quantitative strategies for "pairs trading" might be put on for more 'macro' periods like days, weeks or months. Others cover 'micro' periods where the strategy is expected to be completed within an hour, minutes, or even seconds. As these electronic monitoring and trading systems proliferate, all of the various quantitative algorithms are competing against one another to be the first to execute one or more trades as prices, quantities and order book information change. It is in this context that the reader might hear the phrase "nano-seconds" matter. The various electronic trading systems are competing against each other to be the first to get the new price information, analyze that information, and then be the first to execute against that live price quote. And it is becoming more likely that some other competing trading system is attempting to execute the same quantitative investment strategy.

Toomre Capital Markets recommends that the reader review all of Mr. Skinner's commentary. We surely will return to the subject of cross-asset class trading and Alpha return in coming posts. What do you think about this complex world of quantitative strategies, electronic trading and the hunt for return? Reader comments and thoughts are welcome.