No problem can be solved from the same level of consciousness that created it. – Albert Einstein
On October 4, news broke on all the major market news outlets that – after feasting on a meal formerly known as KCG Holdings, Inc. (KCG) in 2017, which itself was a combo platter made up of GETCO and Knight Capital – Virtu Financial, Inc. (Virtu) was returning to the all-you-can-eat buffet to consider the total consumption of multinational agency brokerage and financial markets technology firm, Investment Technology Group, Inc. (ITG). Of course, this news generated a chuckle around here because it seemed that it was not too long ago that someone was predicting that this kind of pairing would make sense for Virtu – if conditions were such that they needed to bolt something else onto their expanded frame.
Oh, wait a sec, that was us…
To wit, from Alphacution’s post “Virtu Financial: More Acquisitions on the Way, If…” (March 27, 2018):
“One other notable move for significant growth for a firm like Virtu would actually be to add slower turnover, higher capacity, yet lower Sharpe Ratio strategies to the mix. Here, you would be stepping soundly into the wheelhouses of firms like Two Sigma, DRW, D. E. Shaw, or possibly Point72 – and who themselves are up against other powerhouses like Renaissance, Susquehanna, or even Peak 6.
However, this strategy would potentially create the incremental upstream flows for downstream market-making, as if such a firm had gone out into the public market and acquired ITG, Interactive Brokers or – ahem – the husk of Knight Capital…”
Now, since we have been following the evolutions in this neck of the woods so closely – market making and highly-automated trading, in particular – and already had an ongoing model for ITG, it makes sense to throw our 2-cents in here. However, bear in mind, as of the writing of this on Halloween night 2018, Virtu has not yet reported third quarter numbers even though the September quarter has been in the books for 31 days. And, given that the SEC requires form 10-Q (for quarterly earnings) to be filed by firms of this size within 40 days of the prior quarter’s ending, we are all going to have access to that 3rd quarter data any day now – certainly by 11/9. (I’m wagering, Monday 11/5.)
By 10/4 – six days after the quarter end on Friday, 9/28 – Virtu management already knew how the quarter had gone. This timing – to prime all the news outlets simultaneously with a fresh forward-looking story – was not accidental. With Q3 average CBOE Volatility Index (VIX) – the yardstick for the thing that drives most of Virtu’s net trading income (as we wrote most recently here) – of 12.86 coming in lower than Q2 (13.91) and much lower than the blockbuster Q1 (17.35), chances are that internal fundamentals will show weakness for Q3. Hold that thought…
Anyway, before we get into some pictures and specific analysis, here’s a bit of setup for your consideration – and the framing for the question we have been posing regularly of late:
Why is this important?
Alphacution is not (yet) in the business of valuing and opining on stock picks. There are many other smart folks around here to provide details for that. As we offered in strident remarks dating back to March, we will only add that 1) this type of pairing makes sense on the bases of both adjacency and diversification, 2) Virtu has proven itself to be quite skilled at harvesting maximum (and timely) value from transactions like these, and 3) it must be remembered and emphasized that Virtu – including the pieces formerly known as GETCO and Knight Capital, as well as the current proposed target, ITG – were and continue to be in businesses with declining fundamentals. So, after all is said and done, the top lines might grow on an absolute basis – and the deal might be accretive to earnings – but the internals have notable headwinds.
While we are in a position to make informed comments on the outlook for a particular deal in the segments of the ecosystem that we follow closely – and, perhaps most specifically on transactions relating to highly-automated trading and financial technology – this is a secondary aspect of the value Alphacution is trying to offer here.
The primary value that Alphacution is trying to offer is the intelligence these players and their strategic moves expose for the broader ecosystem and the participants therein – for you. Like falling dominoes, this particular move with Virtu and ITG incrementally impacts everything else around it. Prop shops. Hedge funds. Strategy selections. Solution providers. Tech spending. Human capital skills mix. And, many other factors.
Alphacution’s mission is to be there for you, to quantify and ultimately provide more specific predictions on the trends that these kinds of moves represent. Because, as Leonardo Da Vinci has been repeating incessantly atop many of our most recent writings: “Develop your senses — especially learn how to see. Realize that everything connects to everything else.” It is there, in the mass of that interconnectedness, that Alphacution aspires to distinguish itself.
And, it appears – according to our newsletter tally – that there are nearly 20,000 of you now – including within that list a very specialized sub-group; a majority of the senior executives of the most advanced proprietary trading shops, systematic hedge funds, and high-performance technology firms in the world. Because what is happening here will eventually have ripple effects where they are – and wherever you are, too. To have earned some concentrated attention from this rare group is a notable achievement – and a strong signal that we should keep doing what we’re doing…
Ok, coming down off of the soap box, the first piece of our ITG analysis isolates estimated US trading revenue – and compares that to VIX. As you will see in the diagrams that follow, we perform this isolation to optimize the comparison with some other players and to illustrate how, by implication, ITG’s client’s strategies relate to shifts in volatility (See below).
Recall, from prior instruction about the language requirements of alpha, that ITG is not playing a direct role in the alpha discovery part of the process. ITG is mostly in the alpha capture game. It is ITG’s clients – and their strategies – that perform the alpha discovery piece, and then ITG plays a supporting role in that part through its workflow technology and analytics offerings (which, together, averaged 26.4% of total ITG revenue over the 5 years ending 2017).
In this next chart, we first remove the impact of steadily declining US commissions and fees by pegging the average “revenue per share” to the beginning of this 18-quarter series, or Q1-2014. Then, we add total US equity market average daily volume to emphasize ITG’s volume-isolated track record over that period (See below).
Here, we essentially illustrate ITG’s declining relation to a relatively flat US equity market volume with daily averages over the period of 6.9 billion shares per day. Now, as was intimated up top, ITG is quite diversified with strong agency brokerage offerings in Europe, Canada and APAC; in aggregate, growing to counterbalance consistent declines in US brokerage revenue over the past 5 years. As for volatility, this chart shows that ITG’s clients – reported to be mainly hedge funds, asset managers, and other brokers – tend to be more active, with them at least, during periods of moderate to lower volatility.
Lastly, we bring the whole thing home to a very busy chart (below) that combines net trading income for Virtu (pro forma and actual), FlowTraders, and legacy KCG; VIX; US average daily equity volume; and, ITG’s estimated US trading revenue. Note that a simpler version of this chart was recently introduced in the post “Adventures in Speed: @VirtuFinancial, @FlowTraders.” And, also note that the vertical axes have been converted to log scale to get everything to fit reasonably well – but which slightly distorts the visualization.
Anyway, the main point to demonstrate here is that, unlike the speed-dependent “structural alpha” that Virtu (and Flow Traders) are capturing most prominently during volatility spikes, ITG (same as is being shown in the chart above) is more responsive to their client’s alpha discovery signals and likely some “smart-beta” capture as well during periods of moderate to lower volatility.
This lower correlation of flows between Virtu and ITG should help boost – or, at least, support – a newly expanded future Virtu during periods of lower volatility when their current mechanisms tend to struggle.
We will pause here for now – and be looking forward to developing another update to this ongoing saga once Q3-2018 figures are disclosed.
As always, if you value this work: Like it, share it, comment on it – or discuss amongst your colleagues – and then send us firstname.lastname@example.org.
As our “feedback loop” becomes more vibrant – given input from clients and other members of our network, especially around new questions to be answered – the value of this work will accelerate.
Don’t be shy…