Trade Cost Analysis: A Component of Risk Management

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2 Trade Cost Analysis: A Component of Risk Management Coordinator: Jim Bryson As transaction cost management moves into the daily forum, transaction costs must be viewed daily and used to manage risk and minimize costs. Funds cannot continue to measure, predict and evaluate transaction costs in isolation from the original purpose of the trade. And, with more complex strategies in place there is a need to continuously explore alternative trading vehicles that represent similar or appropriate risk exposure. Managers must continue to evaluate cost through cheaper, more liquid products and venues which provide the same tracking exposure but limit costly trading impact. Join us in a discussion on the newer offerings and ideas that involve transaction costs and how they relate to better risk management. 19

3 Overview Elkins/McSherry Measure the Cost of Trading Global Universes The Impact Trading has on Performance Volatility and Risk Exposures Traditional Brokers and Alternative Trading Systems Execution Obligations What is Best Execution MiFID Benchmarks Using TCA Elkins/McSherry TCA Advantages 20

4 Elkins/McSherry Global Trading Cost Consultants Founded % State Street Owned March 1999 Fully Owned Subsidiary March 2004 Analyze Equity and Fixed Income Trading Costs 300 Customers in 12 Countries 145 Pension Funds, 140 Investment Managers, 15 Broker/Dealers Consultant to 5 Global Exchanges 10 th Annual Institutional Investor Survey November 2008 Issue 21

5 How Do You Measure the Total Cost of Trading? Pre Trade Analysis Determine acceptable benchmark cost, time it will take to execute and best possible way to implement Use as guide Must decide on aggressiveness/passiveness behind trade Include commission/fee universes by venue 22

6 Drill down trade costs through multiple dimensions Tabular summary of basket trades and their anticipated costs 23

7 How Do You Measure the Total Cost of Trading? Continued Post Trade Evaluate/measure each segment of trade versus: Pre trade estimate Robust institutional universes of actual trading results Evaluate all trades daily, weekly, monthly, quarterly & annually Look for trends or outliers By venue, trade size, stock, methodology, % of volume, sector, market cap, days of hi/lo volatility Assess the highest cost trades Group trades by cost versus benchmarks A high percentage (70%) of your annual costs come from 10% of the trades Make determination and documentation of why the 10% were outliers Commission analysis by venue should be reviewed as well 24

8 Choose From Wide Selection of Benchmarks Select From the Trade Cycles Exclude Anomalous Trades 25

9 2 nd Quarter 08 EM Global Universe (part I) PRICE COMM FEES MKT IMPACT TOTAL Argentina $ bp 3.48 bp bp bp Australia $ bp 0.11 bp 7.48 bp bp Austria $ bp 0.38 bp 8.39 bp bp Belgium $ bp 0.15 bp 9.22 bp bp Brazil $ bp 1.62 bp 8.17 bp bp Canada $ bp 0.12 bp bp bp Chile $ bp 2.71 bp bp bp China $ bp 9.02 bp bp bp Colombia $ bp 0.08 bp bp bp Czech Republic $ bp 2.27 bp 7.04 bp bp Denmark $ bp 0.23 bp bp bp Egypt $ bp 0.15 bp bp bp Finland $ bp 0.40 bp bp bp France $ bp 0.21 bp 7.41 bp bp Germany $ bp 0.18 bp 7.45 bp bp Greece $ bp bp bp bp Hong Kong $ bp bp bp bp Hungary $ bp 3.33 bp 9.83 bp bp India $ bp bp bp bp Indonesia $ bp bp bp bp Ireland-Buys $ bp bp bp bp Ireland-Sells $ bp 0.54 bp bp bp Israel $ bp 1.40 bp bp bp Italy $ bp 0.25 bp 7.46 bp bp Japan $ bp 0.08 bp 5.58 bp bp Korea $ bp bp bp bp

10 2 nd Quarter 08 EM Global Universe (part II) PRICE COMM FEES MKT IMPACT TOTAL Luxembourg $ bp 0.10 bp bp bp Malaysia $ bp 4.95 bp bp bp Mexico $ bp 0.01 bp bp bp Netherlands $ bp 0.43 bp 7.39 bp bp New Zealand $ bp 0.41 bp bp bp Norway $ bp 0.10 bp bp bp Peru $ bp 0.00 bp bp bp Philippines $ bp bp bp bp Poland $ bp 0.65 bp bp bp Portugal $ bp 0.53 bp bp bp Russia $ bp 0.91 bp bp bp Singapore $ bp 2.70 bp bp bp South Africa $ bp bp bp bp Spain $ bp 0.24 bp bp bp Sweden $ bp 0.09 bp bp bp Switzerland $ bp 0.46 bp 8.94 bp bp Taiwan $ bp bp bp bp Thailand $ bp 1.77 bp bp bp Turkey $ bp 1.92 bp bp bp U.K.-Buys $ bp bp 7.06 bp bp U.K.-Sells $ bp 0.21 bp 7.36 bp bp U.S.-NYSE $ bp 0.13 bp 4.12 bp bp U.S.-NASDAQ $ bp 0.15 bp 5.44 bp bp Venezuela $ bp 9.19 bp bp bp Total 50 $ bp 6.43 bp bp bp

11 Analyze the Impact of Trading Costs on Performance High trading costs have an impact on performance Trading costs have an effect on returns and by reducing them performance will increase Managers must monitor the cost of trading to create transparency and learn from TCA results to minimize cost Evaluate both market impact and commissions By implementing/executing trade closest to inception price is optimal Easier said than done Elkins/McSherry Universes reveal that average implementation costs for NYSE listings is 50 bps but can be over 250 bps Using a recent State Street Performance Universe for equity funds, a typical 27% reduction in trading costs would result in 24bp to the fund s bottom line and move it from the 50th to the 45th percentile. NYSE commission avg bps plus implementation cost avg. of 50 bps = bps 84.6 bps avg. before TCA, down to bps after TCA. 28

12 Costs of Asset Management Global VWAP BPS Portion of Total costs Custody Fee 4.61% 20 Asset Mgt. Fee 30.77% 24 Commissions 36.92% Taxes 10.77% 11 Market impact 16.92% Total 100% Trade Execution Report looks at 65% of total costs 29

13 Costs of Asset Management Global Implementation BPS Portion of Total costs Custody Fee 2.54% Asset Mgt. Fee 16.95% Commissions 20.34% Taxes 5.93% Market Impact 54.24% Total 100% Trade Execution Report looks at 81% of total costs 30

14 Trade Cycle Analysis Closing Price Price to Price Price to Price Implementation Shortfall VWAP or PRICE VWAP or PRICE PM Decision/ Trader Broker Last Order Receipt Receipt Execution Creation LEGEND Portfolio Manager Decision/Order Creation to Trader Receipt (Price to Price) Trader Receipt to Broker Receipt (Price to Price) Broker Receipt to Last Trade (VWAP) Broker Receipt to Close (VWAP) Portfolio Manager Decision/Order Creation to Last Execution 31

15 Trade Cycle Universe NYSE Average +6BP Range 4 to +19BP Price to Price Implementation Shortfall Average +10BP Range 5 to +22BP Price to Price Avg.+3BP VWAP Range 4 to +8BP Arrival Price +34BP Average +5BP Range 4 to +10BP VWAP Average +50BP Range 22 to +102BP PM Decision/ Trader Broker Last Closing Price Order Receipt Receipt Execution Creation LEGEND Portfolio Manager Decision/Order Creation to Trader Receipt (Price to Price) Trader Receipt to Broker Receipt (Price to Price) Broker Receipt to Last Trade (VWAP) Broker Receipt to Close (VWAP) Portfolio Manager Decision/Order Creation to Last Execution 32

16 Trade Cycle Universe NASDAQ Average +7BP Range 7 to +21BP Average +12BP Price to Price Range 9 to +23BP Price to Price Avg. +4BP VWAP Range 6 to +12BP Arrival Price 40 BP Average +6BP Range 4 to +11BP VWAP Implementation Shortfall Average +59BP Range 25 to +107BP PM Decision/ Trader Broker Last Closing Price Order Receipt Receipt Execution Creation LEGEND Portfolio Manager Decision/Order Creation to Trader Receipt (Price to Price) Trader Receipt to Broker Receipt (Price to Price) Broker Receipt to Last Trade (VWAP) Broker Receipt to Close (VWAP) Portfolio Manager Decision/Order Creation to Last Execution 33

17 Elkins/McSherry Institutional Universe Decrease in Customer Costs Commission + Fees + Market Impact = Total Cost Basis Points Basis Points Basis Points Basis Points Q vs 2Q08-34% -23% -30% -32% 34

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19 In a world where we trade portfolios when we have manager transition, or use single security portfolios to represent desired risk exposures (ETF s), how good are our current transaction cost measurement tools? Much better than they were a few years ago and rapidly getting more useful. T-Standard appears to be efficiently representing the costs associated with transitions. In addition to VWAP, TWAP, previous night s close, decision price, evaluation should be made using multiple benchmarks in a flexible analytical environment. Costs should be measured from different starting times; decision, manager, trader and broker. Cannot continue to measure, predict and evaluate transaction costs in isolation from the original purpose of the trade, which maybe to rebalance an index fund, make a short term profit, get out of a bad situation and/or enhance the probability of a long-term appreciation. Need to provide alternative trading vehicles that represent the appropriate risk exposure and are possibly cheaper, more liquid, structured or provide less tracking error. Determine price impact of OTC derivatives by creating universes based on carrying cost, volatility and expiration. Measure trading costs for other instruments such as, fixed income, foreign exchange, commodities and options. 36

20 What new tools will we need to design? Whether we are seeking liquidity from dark sources, spreading out a trade over time, cross-listing on multiple exchanges, etc., trading cost measurement requires a balance between instantaneous impact costs and opportunity (or timing) costs which can be represented in an efficient trading frontier curve. The (theoretical) idea is using one s trading strategy (aggressive, passive, etc.) to then pick off the optimal decision point. Investment decisions are also risk/reward decisions as originally demonstrated by Markowitz using an efficient investment frontier curve. Thus, there is a need to combine the two processes, that is, optimizing both the investment and trading decision at the same time as presented in Robert Engle s work. Provide real time tools geared to prevailing market environment allowing the trader to achieve lower trading costs by understanding the context under which trade was executed. Enhancements that provide assistance with an optimal trading style i.e. manually traded, program trading, direct market access trade and algorithmic trading. Provide further insight into the selection of liquidity pools both internally and externally as well as internal and external crossing 37

21 Where securities are cross-listed on multiple exchanges in multiple time zones (NKE) around the world how do we define measures in ways that they are useful in evaluating the trading and investing process? Develop a global benchmark tweaked for relative depths of liquidity as the global day progresses to provide more credence to the deeper market. Analyze transaction costs when markets close on T+N hour basis and roll up by global market for entire global trade day. 38

22 Given the growing size of institutional trades what is the appropriate length of time to consider when comparing the trading costs among Managers? Brokers? Orders are larger; trade executions on exchanges are smaller, added with fragmentation of many marketplaces, causes for more decisions tied to routing orders to the appropriate liquidity providing venues. Assuming that very large trades are invariably spread over time (and increase the chances of in-complete execution of an order), the appropriate length of time is the original time objective of the trader. Of course, the trader may have only a vague notion, or no idea of the time in which he/she wants to complete the trade. Build universes based on average time by stock globally. Add content specifics such as ADV and volatility. Trades/orders are larger but volume has increased proportionately, coupled with the increase in liquidity providers (pools/crossing networks, internal-external crosses) making up the difference for traditional venues. 39

23 Choose from the wide selection of benchmarks Select from the Trade Cycles Exclude anomalous trades 40

24 Compare and Contrast the Quality and Efficiency of Traditional Brokers and Alternative Trading Systems Average manager uses low touch 45% to execute Now only 30% of trades in NYSE listed are executed at the NYSE Liquidnet, ITG s POSIT and Pipeline are experiencing significant growth These brokers as well as Wave Securities, B-Trade and Lava Trading perform well in our universes Dark Pools have been on the rise as managers hunt for faster and lower cost methods of trading large positions Managers benefit from anonymity and greater control of trade Dark Pools have increased the use of TCA reversion metrics that can assess how the market reacts to a large print BIDS is looking to receive exchange status Traditional Brokers that have performed well recently are Piper Jaffray and Jefferies These brokers use high touch to execute tougher low cap trades Market knowledge can provide results over computerized execution 41

25 What Approaches are Best Suited for What Types of Trades? DMA for small orders Less than 500 shares Not held/high touch for mid size orders for harder to execute illiquid stocks, leave crossing option open Algorithms for slices, baskets or rebalances Size and aggressiveness is key to implementation Large liquid trades can use combination of Dark Pools and Algos Let them help find the liquidity Large illiquid trades must use dark pools or principal trades Challenge is finding the liquidity 42

26 Higher Volatility Could Have A Significant Impact If volatility continues higher, trading costs should increase Managers may need services that have been deemphasized Algorithmic trading benchmarks may become more difficult to achieve Must be properly adjusted for volatility Pre trade models will become less reliable Once again adjustments must be made Cost universes will reveal increases in market impact Use peer comparisons to ensure that your costs remain in-line with the industry, even during changing times Without up to date universes, managers will be viewing their costs within a vacuum 43

27 Understanding Your Best Execution Obligations Regulatory Expectations Create transparency within the trading process Disclose data and analyses on demand Identify and document outliers Monitor managers, traders and brokers Fully understand TCA results Client Expectations Create transparency within the trading process Reduce costs Improve portfolio performance Communicate trading cost data effectively Management and Board Expectations Create transparency within the trading process Measure managers, traders and brokers Constantly improve efficiency together with reducing costs Satisfy client and regulatory concern Improve portfolio performance Provide sales and marketing support 44

28 What is Best Execution? Best Execution has been described by the SEC as: the execution of transactions for clients in such a manner that the client s total cost or proceeds are the most favorable under the circumstances There is no perfect benchmark to measure Best Execution Best Execution is a process not a number Compare costs to the marketplace and to institutional universes Quantify, document and understand trading costs make changes when necessary 45

29 MiFID Article 21 of MiFID directs firms to take all reasonable steps to obtain the best possible result, taking into account price, costs, speed, likelihood of execution and settlement, size, or any other consideration relevant to the execution of the order Establishment of a formal trade execution policy Clients must agree to the trade execution policy Firms must review execution arrangements Firms must monitor execution quality or Best Execution Those executing trades on behalf of customers must be able to provide documentation of adherence to trade execution policies 46

30 Industry Benchmarks Full Day VWAP Industry Universe Available Calculated by adding up the dollars traded for every transaction (price times shares traded) and then dividing by the total shares traded for the day Interval VWAP Industry Universe Available Calculated by adding up the dollars traded for every transaction (price times shares traded) and then dividing by the total shares traded for a particular period of time. For example: 11:00 AM to 2:30 PM was the time when the order was being worked into the marketplace Available VWAP Industry Universe Available Calculated by adding up the dollars traded for every transaction (price times shares traded) and then dividing by the total shares from a particular time to the end of the day. For example: 11:00 AM to 4:00 PM Arrival Price/Strike Price Industry Universe Available Calculated by comparing the stock price from the time you received the order to the actual execution price (Price to Price) Implementation Shortfall Industry Universe Available Calculated by comparing the stock price at order creation time to the actual execution price (Price to Price) Pre-Trade/Benchmark Comparison Measure results versus your internal benchmark or internal pre-trade estimate Any Other Benchmark Upon Request - Open Price, Close Price, Previous Nights Close etc 47

31 Considerations for Employing a Third Party TCA Tool Non-bias quantification and evaluation of the trading process Substantial and granular universe data Industry pulse & updates Client servicing & marketing Many RFPs include questions pertaining to third party TCA tools. Clients have come to expect third party analyses Trading Cost Analysis cannot be entirely outsourced too many trades made for too many different reasons External TCA tools should be used alongside internal processes in order to properly understand and evaluate trading costs 48

32 Global Equity E/M Database On a daily basis, we store every trade that is executed in 47 countries and each trade is time stamped to the closest second. This data are used to calculate average prices, volume weighted average prices, time stamped VWAP s and implementation shortfall measurements for comparison purposes Bloomberg, Reuters, NYSE TAQ The Elkins/McSherry Universe A compilation of actual trade data from 250 large institutions. It contains over 20 million trades, $5 trillion in principal, and 415 billion shares of trading for 1400 investment managers and 2000 brokers. Institutional averages are calculated for commissions, fees, and market impact costs quarterly in 47 countries 49

33 Comparison Summary View Report of other Period Filter by Execution Type Filter by Account IDs Filter by Buy/Sell Filter by Market Sector 50

34 Executive Summary Navigating in different dimensions 51

35 Drill Down by Manager Drill Down by Broker 52

36 Trade Details Security Subset 53

37 Hi/Low 40 Details with Sorting Options Search text 54

38 Arrival Price VWAP Execution Price Price Movement throughout the Day $ $ $ $ $ $ $ $ $ Nasdaq-100 Trust Series 1, Ticker:QQQQ on 12/14/2006 in United States, Buy $44.51 United States Local Time 601, , , , , ,000 1, :06:54 09:34:09 09:44:28 09:53:45 10:01:44 10:10:35 10:21:13 10:32:24 10:44:53 10:59:37 11:21:49 11:49:34 12:18:21 12:47:15 13:16:06 13:45:53 14:03:06 14:23:39 14:40:15 14:59:18 15:17:45 15:40:06 15:55:15 Usa Local Time Price in USD $ 07:06:54 09:34:15 Volume 09:44:45 09:54:00 10:02:05 10:11:04 10:21:51 10:33:28 10:45:52 11:01:40 11:24:21 11:55:19 12:22:16 12:50:26 13:20:45 13:49:17 14:08:31 14:27:50 14:44:29 15:03:26 15:22:32 15:44:06 15:57:58 TotVo l = 101,435,668 Avg Spd = Avg = Close = Low = High = Open = Volume VWAP = price Price

39 Review existing Custom Reports Define New Custom Report Run Custom Report For New Period 56

40 E/M Fixed Income Database The Elkins/McSherry Database Fixed Income market data is used to calculate Benchmark Prices and Average Prices Reuters, Bloomberg, GovPX, TRACE, MSRB, FT Interactive Global bond pricing every day for 86,000 securities Universe includes data from over 25,000 portfolios The Elkins/McSherry Universe A compilation of actual trade data from 80 large institutions. It contains over 5 million trades, $1.5 trillion in principal, 200 investment managers and 400 brokers. Institutional averages are calculated for market impact costs quarterly in 47 countries 57

41 In total As % of total trading (bp) Versus the E/M universe View Report of other Period Filter by Execution Type Filter by Account 58

42 All Exhibits Support Multiple Download Formats View Drilldown Reports From Any Dimension Available Reports 59

43 Drilldown by Country Drilldown by Manager Aggregated Trade Costs At Every Level Trade Details available at any level with one click 60

44 Aggregated Summary of the Hierarchy Every detail of Every Trade Available 61

45 $ $ $ $ $ $ $ General Motors, DomCorpBnd:370442BT on 12/19/2006 in United States, Buy $ United States Local Time 1,001, , , , ,000 1, :43:48 10:13:31 10:29:12 10:46:31 11:16:08 11:31:54 12:04:29 12:31:22 13:32:52 13:42:15 14:03:01 14:04:48 14:38:19 14:49:42 14:56:05 15:27:36 16:01:03 16:48:52 Usa Local Time TotVo l = 4,581,012 Avg Spd = Avg = Close = Low = High = Open = Volume VWAP = Trade = 90.5 Price Price in USD $ 09:43:48 10:13:31 Volume 10:29:12 10:46:31 11:16:08 11:31:54 12:04:29 12:31:22 13:32:52 13:42:15 14:03:01 14:04:48 14:38:19 14:49:42 14:56:05 15:27:36 16:01:03 16:48:52 Execution Price Average Price Price Movement throughout the Day Volume Traded throughout the Day

46 Customize Reports by CUSIP or Bond Type Customize Reports by Manager, Broker, Fund or Benchmark 63

47 Save Reports for Historical Reference 64

48 Summary TCA is a process which quantifies, documents, monitors and manages trading cost Although not required in the US or Canada, having a trading cost analysis process is considered a Best Practice External TCA results should be used in conjunction with internal processes (structured Best Execution meetings, broker evaluations, commission management, trader evaluations, written policies and procedures) Trading cost analysis should provide for positive communication between portfolio managers, traders and brokers A strong trading cost analysis process will improve performance and competitiveness in the market-place 65

49 Thank You