June 2011

Exploding the myth of safe VWAP

Understanding the risks of a VWAP algorithmic strategy

Its not uncommon, particularly across Asian markets, to hear the instruction from both buyside fund managers and traders I dont want to take any risks on the trading, just get me VWAP. The myth that VWAP equates to the market average and is therefore the least risky trading strategy seems to be embedded in the psyche for trading in Asia, resulting in the dominant usage of VWAP as both an execution strategy and a benchmark. While VWAP can be a valid trading strategy to achieve various benchmarks, using VWAP as a benchmark carries a variety of issues. One of which is that using a VWAP strategy to hit a VWAP benchmark is not always, risk free. In fact, recent ITG research shows over 10% of Asias most liquid stocks do not easily fit a VWAP strategy to hit a VWAP benchmark and, if a VWAP execution strategy is used indiscriminately for those stocks, trading costs are likely to soar. ITG recently analysed the most commonly traded stocks across the Japan, Australia and Hong Kong markets to see how easy or hard it is to get close to a VWAP benchmark using a standard VWAP algorithmic strategy. The study covered the ASX 200, the Nikkei 225 and the Hang Seng Composite Index and analysed volumes traded and the volatility of the volume profiles of each stock to measure its suitability for a VWAP strategy. Data was analysed by both the daily and intra-day profiles, though in fact

Ofir Gefen Head of Research & Algo Consulting, ITG, Inc. Ian Jones Quantitative Analyst, ITG, Inc. 212.444.6300 info@itg.com www.itg.com

Distribution of Volume Risk by Market

70% 66% 60% 52% 50% 61% 60%

40%

37%

36% 29%

30% 19% 12% 10% 4% 0% AU HK High Medium Low JP Overall 15% 11%

20%

2011 Investment Technology Group, Inc. All rights reserved. Not to be reproduced or retransmitted without permission. 61711-25695 These materials are for informational purposes only, and are not intended to be used for trading or investment purposes. The information contained herein has been taken from trade and statistical services and other sources we deem reliable but we do not represent that such information is accurate or complete and it should not be relied upon as such. No guarantee or warranty is made as to the reasonableness of the assumptions or the accuracy of the models or market data used by ITG or the actual results that may be achieved. These materials do not provide any form of advice (investment, tax or legal).

Exploding the myth of safe VWAP Understanding the risks of a VWAP algorithmic strategy

the two measurements were highly correlated - ie stocks that traded a similar amount each day also traded on a similar pattern each day, those that didnt trade in similar volumes each day also had volatile intra-day profiles. The findings show that 11% of these stocks had a highly unstable volume profile both in terms of the volume traded each day, and also the intra-day trading profile. 60% had a moderately stable volume profile, and 29% had a very stable profile. In practical terms this means that 11% of the stocks analysed would have a high risk of generating high costs if traded using a VWAP strategy, 61% would have some risk, and only 30% would be very well suited to applying a VWAP trading strategy to get close to the VWAP benchmark.

How big is the problem?

To understand the impact of these findings on trading costs for these stocks, we measured the cost (in basis points) against a VWAP benchmark for a large range of trades. The data shows that using a VWAP strategy for a stock that does not have a stable volume profile (i.e. the 11%) can significantly increase the chances of missing the benchmark and also that this variance away from the benchmark can be up to 50% greater.

BHP AU Intraday volume changes

60% 50% 40% 30% 20% 10% 0% Open Auction 10:00-10:15 10:15-10:30 10:30-10:45 10:45-11:00 11:00-11:15 11:15-11:30 11:30-11:45 11:45-12:00 12:00-12:15 12:15-12:30 12:30-12:45 12:45-13:00 13:00-13:15 13:15-13:30 13:30-13:45 13:45-14:00 14:00-14:15 14:15-14:30 14:30-14:45 14:45-15:00 15:00-15:15 15:15-15:30 15:30-15:45 15:45-16:00 Close Auction

CRG AU Intraday Volume chnages

60% 50% 40% 30% 20% 10% 0% Open Auction 10:00-10:15 10:15-10:30 10:30-10:45 10:45-11:00 11:00-11:15 11:15-11:30 11:30-11:45 11:45-12:00 12:00-12:15 12:15-12:30 12:30-12:45 12:45-13:00 13:00-13:15 13:15-13:30 13:30-13:45 13:45-14:00 14:00-14:15 14:15-14:30 14:30-14:45 14:45-15:00 15:00-15:15 15:15-15:30 15:30-15:45 15:45-16:00 Close Auction

When analyzing intraday profiles and comparing a stock that has a relatively stable profile to one with an unstable profile, the difference can be dramatic. The charts to the left compare BHP in Australia, to CRG (before its acquisition). For each stock we examined the volume traded in each 15 minute bin as a percentage of that days volume, over a rolling period of 21 days. The charts show the minimum and maximum percentage ADV of each bin (vertical line) and the median for each bin (the horizontal line) over the 21 day period. It is easy to see that BHPs profile is relatively stable with most bins throughout the day (except the Close

Investment Technology Group, Inc. (ITG)

Exploding the myth of safe VWAP Understanding the risks of a VWAP algorithmic strategy

bin) accounting for between 2% and 7% and the median around 3%. CRG, on the other hand, fluctuates between 0% and 16% with the median at about 2%. Since VWAP strategies usually follow the median as their target participation rate for each bin, its easy to see why BHP would yield a consistent result vs. a VWAP benchmark while CRG would have a wide standard deviation, if using the stock specific volume profile in a standard or nave VWAP way. We have found similar results across markets in Asia and across similar pairs. This leads to the expectation that a trading strategy which follows stock specific volume profile regardless of the profiles risk will have a larger standard deviation of performance against VWAP than a VWAP strategy which uses a market profile or other smarter techniques for high risk stocks.

So what can be done? Know your algo

Though some of it may be intuitive for those trading the markets every day, its unrealistic to expect traders to monitor and remember which stocks across many markets have a stable volume profile and which dont. Basic or nave VWAP algorithms are often designed to follow strict volume profile logic that adds to the problem. However, as mentioned above, it is possible to use advanced VWAP logic that will automatically calculate the volatility of the stocks own volume profile and, if it presents a high degree of risk, switch to an alternative measure such as a general market profile. Traders should be asking their algorithm providers about the logic of their VWAP algorithms to ensure such safeguards are in place. Additionally, TWAP strategies can be a good method of distributing orders across the day for historically volatile stocks in order to avoid the higher risks of applying a VWAP strategy to a stock that is not suited to it. Better suited strategies such as IS algorithms, cash desks and internal crossing pools are all also valuable tools in reducing the risk for volatile stocks.

Using Smart VWAP to bring consistency

To gauge the extent of the difference between using a nave versus a smart VWAP profile, we looked at the application of the 2 different VWAP methodologies on volatile stocks. The chart below summarizes the percent of orders by performance against a VWAP benchmark. Thus, for example, 42% of orders traded in high volume risk stocks using a smart VWAP strategy achieved a performance of between -5 and 5 bps relative to a VWAP benchmark, while only 26% using a mixture of nave strategies came within the 5bps range of the benchmark. This supports the conclusion that smart VWAP strategies for high volume-risk stocks tend to have more consistent results (lower standard deviation) against a VWAP benchmark than nave strategies.

Investment Technology Group, Inc. (ITG)

Exploding the myth of safe VWAP Understanding the risks of a VWAP algorithmic strategy

Performance Distribution of a "Nave" vs. a "Smart" VWAP strategy for High VWAP Risk Stocks
45% 40% 35% 30% 25% 20% 15% 10% 5% 0% <(20) (20)-(10) (10)-(5) (5)-5 Performance Group in BPS Smart Strategy Nave Strategy 5-10 10-20 >20 12% 20% 14% 17% 16% 7% 9% 7% 18% 26% 42%

6% 2%

5%

Trading Asia Pacific markets presents a range of challenges due to the diversity of the dif ferent individual markets and the stocks within them. This means that traders need to use advanced execution tools such as ITGs range of algorithms, which can factor in these issues and adjust strategy accordingly. The myth of safe VWAP needs to be exploded - given the volatility and the range of trading profiles in Asia, thinking of VWAP as a risk free execution strategy and applying it as the default is only likely to result in higher trading costs and worse performance.

Investment Technology Group, Inc. (ITG)