Why We Need the Plus-Tick Rule, Part IITechnology has demonstrated time and again that it is possible to increase productivity, which can sometimes be viewed, in a way, as increasing the amount of reward for a given level of risk. Often, however, what looks like a great reduction in risk can be seen as more modest as we learn more about unintended consequences -- think of suitcase-sized nukes, for example. Quantitative investing has been around for so long that the term has lost almost as much descriptive usefulness as the term "hedge fund." I will use it to describe the practice of looking for patterns of information which can be predictive of the price movements of securities to an extent where it is possible to take advantage, usually using computer power.
Uneven ExecutionTo make any money by actually investing in the basket rather than selling access to the names in it, it is not enough to simply predict its movements, which may be accomplished by analyzing large and constantly improving databases, you must also profit when your predictions turn out to be accurate. This means that you have to have capital committed, long or short, to a very accurate representation of your basket. This requires efficient trade-execution systems so you can get all of your capital committed, or released, from the basket, within a short enough period of time so that market movement "noise" doesn't wreak havoc with the price assumptions built into your predictive model. Moving money in and out of baskets, of course, was a logistical pain in the neck until the advent of decent basket-trading software. This has been has been available for less than a generation, and for most of that time its main utility has been the ability to get a whole bunch of trades done simultaneously, if not well. The issue of best execution on each individual security was, and is, more complex.
The Influence of Big TradesIt is impossible to derive the "best execution" level for a given trade when the trade itself influences what that level might be. This is a common and intractable problem found in many fields of science -- how to observe the behavior of what you study without affecting the way it works. It is exceptionally difficult, and eventually impossible, to compare yourself with absolute accuracy against a market in which you are a large player.
Further Distortions From the Fee SideThe profit-oriented trader, at least, might only cause sloppy pricing in a subset of the securities in a basket, in cases where the rest of the securities were executed well, so that the overall price objective be still obtained. Unfortunately, the fee-driven trader knows no such limitations, has no incentive to consider the relative level of prices received, and further, is under mandate to execute. When a significant portion of the capital being invested in the underlying index comes through such facilitators, the notion of comparative valuations between individual enterprises gets lost in the sea of broad-market trading, while correlations go to 1. How many people, running how much money, were really aware of how ineffective the levered ETFs were (when used in their promoted direction) over multiday holding periods until Eric Oberg wrote that beautiful piece on them a few weeks ago? It may not be a coincidence that you could borrow the short ones such as the UltraShort Financials ProShares ( SKF) all day long until just recently. Anecdotally, my wife was at a conference last fall when a speaker, the CEO of a $10 billion-plus fund of funds who was clearly uncomfortable with the proliferation of those instruments, posed such a question about them to the 100-person audience, and received no response. When I emailed him the answer to his question, he was appreciative enough that I don't think he had received many others. The good part is that as long as the capital committed to such strategies is a minor part of the overall capital employed in the market, the tail won't wag the dog; the market picture in any given security will not be affected much by the execution characteristics of the individual order in that security which is part of basket trades entered. The problem, of course, is that quantitative strategies proved out pretty well for a long time, so they have attracted lots of capital. Go back, for example, to the granddaddy quant model of them all, the S&P 500. Since someone made the claim that only a small percentage of active asset managers actually outperform the S&P 500 over long periods of time, many investors have given up trying. This giant exercise in exalting mediocrity (guess where I stand on the issue) has all kinds of things to recommend it. It's cheap, because you don't have to pay managers to work hard to discover which companies might actually do better than their peers, you don't have to explain why you underperformed by picking your own portfolio, and it's diversified.
A Check on Undue LeverageThe plus-tick rule, of course, throws a monkey wrench into the works, as the ability to sell short instantly is complicated by the necessity of waiting for someone to come along and buy the stock from you. This is not the only hindrance created for basket players by the rule. Think for a moment what might happen when a basket order is entered near the close, and only 85% of the stocks in it get executed. Which is better, taking the overnight risk, or executing the rest of the stocks in the aftermarket, where there is less liquidity? It all depends on how wedded you are to your basket -- very, if you are an index ETF, of course. If you did well on the first 85% of your positions, how much will you care about the execution levels on the rest, especially when all you have really promised is that you will deliver the basket at the index level, which your trade, of course, will help determine? The question is whether all the banging and lifting enabled by this basket activity in the absence of the rule is actually bad. I think it is. I've already argued that without the counterweight of a plus-tick rule, there will be more banging than lifting. Even in an imaginary world where there is a natural balance between the two, volatility would be elevated by the execution behavior I just described, and volatility is expensive for the whole global economy. The absence of the rule enables all kinds of other trading as well. Take the following example, lovingly referred to on many desks as the "Taliban trade" or by Jim Cramer as kesselschlact: You might get short some common stock, then go out and buy credit default swaps, or CDS, on some tranche of the company's debt, boosting the premium so much that people start to wonder whether there's a problem at the company. As the stock falls, you could help it along, if you like, by hitting bids indiscriminately -- there's no plus-tick rule, after all. One of the powerful things about this trade is all the leverage you might have available to apply to it, not at all limited to that determined by Fed or house margin rules, either. When you buy CDS, you get not only the normal option leverage but also the de facto leverage that comes from the fact that even though the swaps cover one series of security, the prices of all of the company's securities depend on the company's credit standing. If someone starts to pay a whole lot for protection against the default of one security, the "cockroach theory" would indicate that holders of the company's other securities might wonder about the merits of holding those, too, and start selling, or buying swaps themselves, abetting the cycle of uncertainty.
Know What You Own:Other ProShares funds include the ProShares Ultra Real Estate ETF ( URE), the ProShares UltraShort Real Estate ETF ( SRS), the ProShares Ultra Financial ETF ( UYG), the ProShares UltraShort FTSE/Xinhua China 25 ( FXP), the ProShares UltraShort QQQ ( QID), the ProShares UltraShort Oil & Gas ( DUG) and the ProShares UltraShort Industrials ( SIJ).