Conservative Approach Tempers Federated Investors As Firm Deploys Technologies for Trading, Data, Risk

Originally published May 12, 2008

In a market environment that has become more volatile since last summer’s sub-prime crisis, Federated Investors is holding to its conservative and methodical approach. With more than $330 billion in assets under management, in money market, fixed-income and equities mutual funds, Federated conducts its investment business through a structure comprised of many different organizational units and committees, each focused on a key area. The investment advisory group includes a trading unit, whose team members work out of offices in New York, Boston and Pittsburgh. Besides fixed-income and US and global equities, the team trades a wide range of investment instruments, ranging from short-term securities, such as commercial paper and repos, to derivatives such as interest-rate swaps, total-return swaps, credit default swaps, options and futures. Global Investment Technology spoke with Timothy G. Trebilcock, Chief Operating Officer (Trading), to whom the trading team and middle-office support services report.

GIT: How is the current business environment being affected by the sub-prime crisis?

TT: The volatility in the markets with the most recent crisis, since last summer, weighs heavier on the traders in trying to find transparency in the market. A traditional asset manager like Federated is not looking to get overly creative or take on unnecessary risks to try to take advantage of these anomalies in the market. We’re a relative value player. In what the market has been going through, it’s about finding liquidity and transparency. Away from the sub-prime crisis, we’ve seen a lot of fragmentation in the equities markets based on new regulation such as Reg NMS and MiFID. We envision that fragmentation will eventually stop and we will then see some consolidation in the market.

Traders have to be aware of all of the tools that are available, even if they may not always be products that are taken advantage of. We don’t necessarily have every algorithm on our desktop or dive into every dark pool that’s available, but we do spend a lot of time on understanding what the landscape looks like so we can figure out what’s best for Federated on any type of order we make. It’s a game of understanding the evolving landscape in equities.

GIT: What connections between market participants could be maximized to achieve the greatest liquidity? Is there something market structure-wise or technology-wise that would facilitate a better trading environment?

TT: In this case, I would probably lean toward my comfort zone and put on my fixed-income hat. There have been big pushes to make the fixed-income marketplace equally electronic as that of equities. That’s quite a challenge because the fixed-income market is very different and much less commoditized than much of the equity market. There are a lot of different platforms. Fixed-income is not as connected and does not enjoy straight-through processing nearly as much as equities. We can make up ground in fixed-income and see a greater market share for commoditized products go electronic, but we also have to balance that, as the equity model has proven, to still have good connectivity with the brokers, and use those electronic trading platforms as just one aspect of the trade. At the end of the day, you need to balance how a market that is primarily agency based trades compared to one that is principal-centric.

GIT: Do you see the sub-prime crisis becoming a catalyst for the convergence between fixed-income and equity trading disciplines? Would any analysis buy-side firms do on fixed-income bear on the equities they trade, for example?

TT: This sounds good on paper, but for a lot of the fixed-income markets, liquidity is so much more challenging in some of these scarcely traded names, like munis and high-yield corporate bonds. They have liquidity issues that challenge the ability to use an electronic trading platform efficiently. The Municipal Securities Rulemaking Board and efforts by trade associations have brought some transparency to the marketplace, but at the risk of losing liquidity.

GIT: You say liquidity will always be a great challenge. Buy-side firms typically get indications of interest (IOIs) from their brokers. Should buy- and sell-side participants be offering IOLs — indications of liquidity — instead?

TT: On the fixed-income side, some message aggregators are popping up that are attempting to address the IOL equivalent in fixed income. Systems like MarketAxess and TradeWeb are really creating transparency, more than liquidity. Historically on the fixed-income side, brokers would send Bloomberg messages, e-mails and faxes on positions that they are long or short on. Traders are getting hundreds of e-mails and Bloomberg messages daily about specific actions they see. Now these information aggregators are popping up, so on a particular issue you can see who’s showing it and at what price. This makes it easier for the trader to discern where liquidity is or isn’t on any given day. That’s a transition on the fixed-income side.

GIT: Are there any tools or creative ways your traders employ to probe for liquidity or to make trading more efficient?

TT: Federated uses the standard tools widely available in the marketplace. Technology is not always the silver bullet. You can feed a lot of data into different systems to determine what to do with a security — finding out the trading dynamics, what’s going on in the marketplace. But whether the issue is fixed-income or equities, you need a solid relationship with a sell-side firm, and this detective work helps you better determine liquidity. For equities, we use a handful of algorithms that are generally broker-sponsored. We do look through the dark pools and some of the platforms that present them to us.

GIT: Has the rise of hedge funds and the quest for alpha put pressure on investment companies to evolve their products? Might hedge fund offerings and mutual funds and managed accounts services converge?

TT: You’re seeing it to a great degree already. The growth of an enhanced strategy that is ’40 Act-eligible [Investment Company Act of 1940] continues to rise, whether it’s 120/20, 130/30 or another strategy. The marketplace continues to launch many products that fill that space. That is a way to avoid deviating too far from a model, but still offer another product in the lineup to take advantage of their expertise in those core competencies. Prime brokers are essential to facilitate creation of those strategies.

Their clients have to understand what prime brokers do and the issues associated with using them. A ’40 Act fund isn’t allowed to custody its long assets anywhere but a bank custodian, so really the prime broker is just dealing with the short side. The traditional asset manager hasn’t typically had to think about financing or short covering, as it relates to this aspect of the business. In this environment, credit becomes a much bigger aspect of the strategy. A ’40 Act fund needs a custodian for one part of its strategy and a prime broker for the other part. A manager must be able to locate securities if you need to borrow them in the marketplace to cover the short. They have to employ prime brokers to do that because straightforward custodians don’t provide that service.

GIT: What kinds of business and market information do you and your colleagues need to see daily to be better informed on operations? What types of information can Federated supply internally?

TT: Across the spectrum, for an asset manager that participates in a lot of different markets, there’s an increasing demand for ad hoc reporting and data synthesis. Everyone has a unique set of reporting needs. Having a technology team capable of handling this is becoming more important for us. We try to standardize where it makes sense. The ability to do ad hoc reporting and real-time data synthesis is in increasing demand.

GIT: What are the challenges posed by the growth in alternative investments, particularly fixed-income derivatives? How will the sub-prime and liquidity crisis affect the outlook for derivatives?

TT: Everybody looks at their footprint on what they perceive as new capabilities, such as alpha strategies for products. They ask themselves if they fully understand the risk involved with these products and are comfortable with it, and whether liquidity or transparency have changed? We continue to look for ways to connect technologically, not necessarily in a trading platform for some derivatives, but getting them into the OMS to trade differently.

Whether it’s the performance attribution system, front-end analytics system, or being able to slice and dice these products to truly understand what you see, risk management continues to be a challenge in the technology landscape right now.

GIT: How would you contrast the business model and challenges facing buy-side institutions today versus five years ago?

TT: Best execution has become a much bigger buzzword in the industry and so the whole electronic trading arena is much more mature than it was, even though there are many areas where better capabilities may be needed. We have a much higher level of automation and straight-through processing. Have we created an environment that gives us better execution than we had a few years ago? The answer may be in the analysis of that automation in streamlining of technology. Whether it’s trade-cost analysis, best execution analysis or attribution, if you can do everything in one-stop shopping with all your other systems from a connectivity point of view, the better it is.

GIT: What is the most valuable insight that you can share based on your experience in the fund management industry?

TT: Our culture at Federated is conservative and takes a methodical approach to the business and the new products and opportunities that are available. I fully embrace that. You always want to look to see how you can get better, but as we’ve seen in this last year, you can reach too far for performance, and there’s been a lot of carnage along the way. Our model is proving this over time when we look at everything, understand everything, and see where it all fits in our conservative book of business. Being a little slower to adopt some of these unproven strategies and products has allowed us to further define what we think is a more conservative approach to any of those markets.



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