STEP 1. What Drives the Stock Market?
People do. More specifically, the knowledgeable, experienced professional traders that execute large volumes of stocks and ETF shares – block traders and market makers.
Equity markets have become dominated through the years by large mutual funds, pension funds, hedge funds, endowments and other institutions whose size require them to make investments in large transactions, straining the capabilities of traditional market making mechanisms. Block traders and market makers serve as volume dealers in large block transactions, providing the market liquidity necessary to satisfy these important customers
In many cases, block traders account for more than fifty-percent of the trading volume for an individual ETF security.
STEP 2. Who Are the Block Traders?
Block traders (sometimes referred to as market makers) are the institutional traders that execute transactions for the brokerage firm's largest and most prestigious clients. Block traders and market makers serve as volume dealers in large block transactions providing the market liquidity necessary to satisfy these important customers.
On any given day, the most active equities, stocks and Exchange Traded Funds (ETFs), will be traded in large volumes through numerous block traders and their respective firms. It is this community of institutional traders that in many ways drives the market.
Block traders often specialize in a handful of ETF securities or industries in order to optimize knowledge flow and information resources.
STEP 3. What do the Block Traders know?
Everything there is to know about the securities they trade. As a class, block traders are the most experienced and best-informed investors in the world. Their individual careers and firm's profits demand excellence in forecasting the near-term prices for specific stocks and ETFs.
The information resources and analytical skills of institutional clients require block trading firms to maintain extensive, immediate, world-wide information-gathering systems built over decades to ensure that fair and competitive markets be provided on a continuing basis to all investors. The highly experienced institutional participants in this process reside at the apex of knowledge, research and information about the ETF issues they trade.
Further, they are in frequent daily personal contact with those investors most likely to take actions that will force ETF prices to move. They see it happen. They help to make it happen. This is called order flow. They know what their clients are likely to do.
Institutional Traders generally have the best insight of any single source about the future price forecast for a given ETF.
STEP 4. Executing the Block Trade.
In the course of executing the trade on a client's behalf, the institutional trader must frequently take at-risk positions in the ETF (providing instant liquidity to the large client) and then transition the shares into the market in an orderly fashion. It is not uncommon for a particularly large block trade to be managed over the course of several days.
Over time, the block trading community has developed sophisticated methods of protecting their personal and firm profits while managing large block trades.
STEP 5. Institutional Insurance.
For both the block trader and market-making firm, the profitability associated with executing a given trade is directly correlated to the manner in which the trade is hedged or "insured" against subsequent price changes. Since disadvantageous price movement can significantly impact the profitability of the transaction, block traders hedge at-risk positions based on their unique forward looking price insights for that individual ETF security.
The hedge or "insurance" created by the block trader is adjusted based on their unique assessment of what their clients and other institutions are likely to do in a particular ETF. Given that the hedge costs the institutional trader part of his profit in the transaction, all the resources of the firm are maximized to gain insight into the likely short-term ETF price behavior. If it is believed by the market maker that the ETF price will rise in the coming days and weeks, then the hedge can be adjusted to achieve greater profitability for the trader and firm.
In many cases this represents millions or tens of millions of dollars of value in a single trade. Judgments like this are made 20,000 times a day on blocks each worth $1 million or more. These are actual ETF trades with a substantial amount of money behind each one.
Institutional Traders hedge subsequent price changes based on their uniquely developed expectations and near-term outlook for the ETF in order to maximize profitability of the trade.
STEP 6. Enter the Way Method.
Peter Way, CFA, co-founder of Institutional Insights, has developed, over the course of many years, a method and analysis model for providing transparency into the hedging practices of block traders using publicly available exchange traded funds data.
The proprietary analysis behind Institutional Insights takes advantage of that transparency to create organized intelligence not found elsewhere in the ETF strategy universe. The analysis is distilled down to providing subscribers with forward-looking ETF price forecasts for over three-hundred Exchange Traded Funds (ETFs) based on the collective wisdom of the community of block traders that specialize in each security.
The result is the ETF price range forecast for a given ETF security based on the collective judgments of institutional traders around the world. Another way of thinking about the data: Our analysis identifies those ETFs that the block trading community considers to be undervalued or mispriced. The time required for the ETF price to rise to meet the block traders' expectations is generally measured in weeks and months, with notable exceptions on either end of the bell curve.
Given the deep experience and information resources of this expert community, the ETF prices forecasted are usually reached.
STEP 7. More Math and Probabilities.
In the stock market, as in life, there are no certainties, only probabilities and trade-offs. In order to make the insights gained from the block traders more relevant and useful to subscribers, further computations are run in order to provide detailed odds and payoffs analysis for each ETF tracked.
The final calculations of investment desirability are the culmination of extensive probability analysis across both the current market data and how well previous range forecasts and rankings have actually worked out. In effect, the historical track record of the community of block traders is factored in to the analysis for the final calculation of probabilities.
While Institutional Insights can in no way guarantee the outcome of the daily reported ETFs, we can provide subscribers with detailed probability analysis (odds and payoffs) so as to close the information gap and allow subscribers the opportunity to make more-informed investment decisions and better manage risk.
STEP 8. The End Result.
The output of the system is a daily ranking of over three-hundred exchange traded funds, indicating those with the highest probability of price movement and the likely magnitude of their price movements. It's a simple approach, and it works. What more can you ask of an ETF Strategy?
For each top-ranked ETF, Institutional Insights also calculates odds and payoffs, to the upside, downside and combined (all represented as percentages). This allows subscribers to not only see the top ranked ETF's based on the forward-looking ETF price expectations of professional block traders, but also the potential profit associated with the probability of the ETF price move. The odds and payoffs calculations provide an easy and direct means of analyzing risk and reward on an ETF by ETF basis.
Finally, a target ETF price is calculated based on the analysis in order to provide a clear exit opportunity and completion of the trade. Generally speaking, the profit targets tend to be in the range of 6% to 12% depending on the security, the market, and most importantly, the block traders' outlook for that individual ETF security. The time horizon for the insights derived from the market makers is on the order of a few weeks up to a few months to achieve the final ETF price target. These shorter gains provide a very important opportunity to compound the returns earned several times in a year, producing results far above those of long-term investing.
A critical concept to understand is that the daily output contains only information received from the market and is based solely on the data surrounding the community of institutional traders. No individual judgments or recommendations are introduced to the final results by Institutional Insights.
STEP 9. Accuracy of the Insights.
After many years of monitoring the ETF data and numerous model portfolios, the accuracy of the forecasts generated by the block trading community tends to be in range of 70% accuracy for stocks and 80% plus for ETFs, in terms of profitable transactions.
It is important to remember that the data is based on the collective judgments of the population of institutional traders on any given day. Since that population is comprised of people, they can and often do make mistakes. Like all mortals working in the investment world, they are subject to emotional and behavioral anomalies that cause them to make suboptimal forecasts. However, taken as class and over the long term, they are the most accurate in forecasting future ETF prices of any single community of ETF traders. Those who repeat mistakes don't remain long in positions of risk to their respective employers.
As with any investment service, past performance is no indication of future results. Investing in and trading equities involves risk of financial loss. This service is recommended for experienced investors.
STEP 10. Why ETFs?
Institutional Insights' data model tracks both actively traded stocks and ETFs. Over time, however, we have found the ETF data to be more reliable and accurate with respect to the block traders' forecasts. Thus, we have decided to include only exchange traded funds results in the service at this time.
Additionally, it is the contention of many investment professionals that etfs provide an exceptionally advantageous means of portfolio creation, trading and management. The diversification, liquidity, volatility characteristics and low fees make them a good choice for investors of all sizes and levels of sophistication.