Market Microstructure, the New Frontier for Long-term Portfolio Optimization

Co-authored with Steve Krawciw

Market microstructure is traditionally thought to aid execution traders and market makers, the two types of intraday financial practitioners continuously interfacing within the markets. For longer-term investors, such as pension funds and long-only hedge funds' portfolio managers, market microstructure is usually not considered to be a variable in portfolio optimization. However, the latest research from shows that long-only managers ignore the effects of market microstructure at the expense of their clients' portfolios. This note summarizes the latest findings.

First of all, what is market microstructure? In broad terms, the science of market microstructure that examines the evolution of orders and order matching that occur in an exchanges' limit order books. A limit order book is a central marketplace for any given financial instrument, i.e., a stock, futures contract, bond, foreign exchange rate or an option. Limit order books have been shown to be universally superior tools to match buy and sell orders in finance. The order matching process that occurs in each limit order book is analogous to the matching of produce and customers at a grocery store:

1. The grocers desiring fixed prices place their merchandise on the shelves of the store. In financial lingo, the fixed-priced wait-for-customer merchandise displays are known as limit orders.
2. The customers who want merchandise right away and at the best available price pick the merchandise off the shelves. The right-away customers use what in finance is known as market orders to accomplish their purpose.
3. Exchanges ring up (match) the orders, making the transaction official.

Market microstructure deals with the minute aspects of stocking the shelves (i.e. who gets the best display space), customer arrivals (when do most customers arrive and who has the biggest budgets), and similar issues. In the process, market microstructure incorporates topics like high-frequency trading and runaway algorithms.

Most market microstructure activity is sticky; the typical dynamics persist from one day to the next, even though in the very short term variability can be significant. As a result, phenomena such as volatility and risks associated with aggressive HFTs lend themselves well to extrapolation in the near future on the scale of days and weeks.

Market microstructure does little to predict long-term returns, but it works in predicting intraday risks. Long-term portfolio management concerns itself with increasing returns of investments while minimizing risks. By accounting for the market microstructure risk, long-only portfolio managers can reduce volatility and significantly improve the performance of their portfolios. As this AbleMarkets note illustrates, by using the information about the proportion of aggressive HFTs present in the markets to adjust the relative weights of holdings in a portfolio, investment managers can significantly optimize portfolio performance.

In addition to the risks associated with HFT, the understanding of market microstructure can help predict flash crashes days ahead (for any given security), minimize slippage when placing trades, and, of course, predict short-term price movements in the markets. All of these features help improve portfolio performance even for the largest-scale pension funds and hedge funds.

Why has market microstructure been left orphaned by portfolio managers until now? First, the data required for market microstructure analysis used to be scarce. Few organizations archived tick-by-tick data beyond the 21 day timeframe mandated by the regulators. Second, computing was too slow and too expensive to make market microstructure analyses economical. Third, transaction costs used to be hundreds of times higher just a decade ago, making gains from market microstructure comparatively negligible. Today, in the markets with razor-thin profits, every penny and even basis point (1% of 1%) count.

Of course, market microstructure analysis is not trivial and requires extensive understanding of the issues underlying modern market dynamics. Also, markets do not stand still - innovations in order routing, exchange and other trading venue configurations, pre-trade and post-trade risk analytics affect market microstructure and many associated models. Staying on top of modern evolutions in the markets is much more than a simple job. However, incorporating market microstructure analytics into financial decisions is no longer an option but a requirement for sound portfolio management.

Steve Krawciw is CEO of Irene Aldridge is Managing Director of Able Alpha Trading, LTD., and and author of High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems (2nd edition, Wiley, 2013).