Professional investment vehicles allocate a fixed percentage of their portfolios to specific sectors, such as equities and fixed income. At various points in time, those professionals may adjust those allocations, creating huge movements of money that can be exploited if watched closely. And while today’s electronic trading systems can efficiently and effectively bring buyers and sellers together, there are still important roles that must be fulfilled by the floor trader for certain transactions. One example is when these large reallocations occur.
The shift to electronic markets as the main engine for price discovery has threatened the existence of the floor trader. However, strategic orders, due to their size and nature, require a level of finesse that can only be achieved by trained and battle-hardened individuals. By learning to recognize asset allocation from the floor, the importance of the floor trader in the execution of such an order and how a trader outside of the trading pits may be able to capitalize on an asset allocation play, you can improve your odds of success.
ALLOCATION MATTERS
The term “asset allocation” refers to how an investor distributes investments among various classes or vehicles. Most portfolios attempt to define their allocations: 50% for equities, 40% fixed income, 10% commodities, etc. Investors may define their allocations further by subscribing percentages to be allocated within a sector: large cap, small cap, emerging markets. Various market activities may cause an investor to alter the portfolio and weight one general sector more or less.
Since the surprise rate cut by the Fed on Aug. 17, 2007, as the subprime crisis began to unfold, there was a movement of monies to physical commodities, gold in particular, from equities (see “Equities & commodities”). Many investors saw both a tougher economic period and inflation leading them to have more exposures to investments that appreciate in an inflationary period. Astute traders recognized at this time that it was better to hold hard assets than paper assets. After a series of interest rate cuts and Fed actions, institutions began to suspect that the worst of the problems may be behind them and then sold gold in a reallocation trade. The selling of gold freed up cash, which was then reinvested into equities.
Once the asset manager knows which vehicles to use in the allocation model, he must decide on the percentage of assets to allocate per investment. Many fund managers make known this allocation to their investors. One of the most common allocation models is 50% in stocks, 40% in bonds, and 10% in alternatives. Because most investors know the common asset-allocation weightings, the key to developing a strategy to outperform the market is in the tactical allocation of these weightings. This tactical allocation is where the sophisticated money manager uses the futures markets to try to enhance portfolio performance.
Simply put, the tactical approach is a strategy that fine-tunes the money manager’s positions. Using tactical asset allocation as an investing tool allows the money manager to modify asset allocation holdings according to specific market conditions. For example, while the main asset allocation model is 50% stock, 40% bonds and 10% in alternatives, a tactical asset allocation strategy would be to increase holdings in stock by 5% while simultaneously decreasing the position in bonds by the same amount. After the tactical allocation, the portfolio would reflect an allocation of 55% stocks, 35% bonds and 10% alternatives.
While the general strategy has been defined, the question remains: How do you identify when a tactical asset allocation is taking place and, more importantly, how do you profit from it?
VIEW FROM THE PITS
Large, strategic institutional and fund asset allocation trades are often executed via open outcry. While it may appear that these transactions take place during a single trading session, in reality, these huge positions often take days to accumulate and often set the short-term trend due to their massive size and staying power.
Trades in the $1 billion to $5 billion range do take place, and they require days to work into the market. Most of the activity of these trades center on a tactical asset allocation between stock equity futures and Treasury instruments. The role of the order filler is to execute the order with as minimal impact on the market as possible.
On April 16, 2008, the U.S. Consumer Price Index number came out higher than expected. Traders read this report as a sign that the Fed may have to stop its aggressive easing campaign. At approximately 9 a.m. CDT, the first wave of tactical asset allocation orders came into the S&P 500 pit. While buy orders were being executed in the June S&P 500, sell orders were simultaneously being filled in the June Treasury bond market (see “Treasuries, unwound”). This initial allocation lasted about an hour.
After 10 a.m., the focus was on the Treasuries as traders made huge adjustments to fixed-income portfolios. Floor traders sought to hold the market steady and not create any price aberrations. Buying and selling was kept at just about even in the S&P 500 pit as the big play was in the Treasuries. At approximately 1:15 p.m., with the selling in the Treasuries nearing its conclusion, large buy orders came into the S&P 500 pit and offers were taken out. After holding inside a tight range for several hours and allowing traders to lighten up their positions in Treasuries, institutional buyers came in with a vengeance to drive the S&P 500 market to a new high on the close (see “S&P upswing”).
This is an example of how an asset allocation may take place in pieces rather than simultaneously. Instead of trying to time each buy in the S&P 500 with a simultaneous sell in the Treasuries, the institutional traders allowed the fixed-income market to sell off, freeing up cash to be invested in the S&P 500 market.
AHEAD OF THE MARKET
Years of experience filling such orders offers an understanding of the price patterns that precede them. One such pattern is based on time. Executing buy orders often match simultaneous pressure on the Treasury bond market, with those orders flowing into the market at 30-minute intervals. A trader could capitalize on this type of allocation by studying the swings of the S&P and bonds in half-hour increments.
Another observation has to do with market players. For example, Japanese firms tend to execute orders in tandem. In other words, if Nikko is buying S&P 500, their executing brokers are likely to be competing with Nomura, Daiwa and every other large Japanese trading house trying to complete the same type of strategic order. Such occurrences are nearly impossible for an upstairs trader to key into without a link to the floor. In the absence of a willing pit presence, the best source of this information is a squawk box or some other source of live floor commentary. This knowledge, coupled with observance of the timing of these orders, may provide enough information to capitalize on the aberrations created in the S&P 500 and Treasury markets.
It is important to know whether the order’s origin is domestic or overseas. The source of the transaction gives the trader an indication as to when the order might be complete. Observations of these tactical asset allocations suggest that they are short term in nature.
Often, the orders stop at approximately the same time that European fund managers are leaving for the evening. Despite that they all have large trading operations and the capability to trade around the clock, these traders often complete their allocation on the European close, around 11 a.m. CDT. A European or Asian order is usually 75% complete by the European close. A domestic order, however, usually continues into the U.S. Treasury bond close at 2 p.m. Large volume surges are often seen during these two periods (see “European effect”).
One way to determine if an asset allocation trade is domestic or European is to take a look at the overnight trade. If it is clear that there is a divergence between equities and Treasuries in overnight trading, a sharp trader may want to pay attention to this scenario at the U.S. open. The allocation effect may last into the European close (11 a.m. CDT) and as the institution nears the end of its trading day, there may be a huge surge in the markets as they try to finish the allocation before the close. In this example, you can see the steep rise in the equities along with the simultaneous decline in Treasuries. After the European allocation, both Treasuries and equities flattened out, although the equities continued to climb a bit.
The stock index futures pits are home to many types of traders executing many different trading strategies for a variety of reasons. Through experience and observation, we can decipher a few of these strategies, especially in the area of tactical asset allocation.
The key to exploiting this type of strategy is to identify it and act quickly. By knowing ahead of time what a tactical asset allocation is, who the players are, and how long it is likely to last, a sharp trader should be able to act upon some of the aberrations
created in the market by large institutional traders.
Jack Bouroudjian is a principal at Brewer Investment Group, LLC and previously served on the board of the CME. He is a CNBC market analyst, appearing frequently on Squawk Box, and is the author of “Secrets of the Trading Pros” (Wiley, 2007).
