ATMonitor Commentary February 2012 issue
Transaction Cost Analysis Q&A 8 things you wanted to know about TCA but hesitated to ask
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Transaction Cost Analysis Q&A ATMonitor Commentary
Foreword This is not an academic paper on theoretical discussions but rather a series of practical questions and answers that members of MyATMonitor have asked and industry experts answered. Our primary goal is to bring knowledge that may be useful to traders on the buy-side. In fact, this philosophy is well reflected in the very heart of MyATMonitor, a reliable, independent and trusted peer-group network of and for buy-side only institutional traders. This publication has been compiled from ongoing Q&A activity on the MyATMonitor Expert Panels. At the time of publication, MyATMonitor Expert Panel topics include Dark Pools, Commission Sharing Arrangements, EMS/OMS Relationships, Fragmentation of Liquidity, MiFID II and Transaction Cost Analysis and Best Execution. The ATMonitor team would like to thank all members and experts that have generously contributed to the success of MyATMonitor. ATMonitor Team.
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Transaction Cost Analysis Q&A ATMonitor Commentary
Experts Panellists: Robert W.A. Kay Head of Analytics,TradingScreen (UK) Ltd Robert Kay is a Founder and Director of GSCS Information Services and Head of Analytics at TradingScreen. GSCS Information Services has provided transaction cost analysis to institutional asset managers for more than fifteen years and was acquired by TradingScreen in 2009. Robert has spent more than thirty years in financial services, both in the UK and North America. He has worked for large organisations including Morgan Stanley, Goldman Sachs and The Chase Manhattan Bank as well as setting up, running and selling a number of businesses including TheTRADE magazine and GSCS Information Services. Robert graduated from Oxford University with a BA in Mathematics and a Masters in Statistics.
Michael Sparkes Managing Consultant, Investment Technology Group Michael Sparkes heads ITG’s team of consultants servicing European clients with TCA and related post-trade analytical products and services. Michael has more than 25 years’ experience in the City, including several years as Head of International Equities at Morley Fund Management. He was a Director of Morley’s asset management operations in Japan and Singapore, and also spent two years as Managing Director of a stock-broking company based in Amsterdam and Antwerp. He started his career at British Airways Pension Fund as a US equity portfolio manager. Michael is a graduate of Cambridge University.
Disclaimer: The content of this report is provided for informational purposes only and has been obtained from sources believed to be reliable, but it is not necessarily complete and its accuracy cannot be guaranteed. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any transaction. Moreover, this material should not be construed to contain any recommendation regarding, or opinion concerning, any security. Any views expressed in this report are those of the individual experts and do not necessarily represent the official view of ATMonitor or participating organisations.
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Transaction Cost Analysis Q&A ATMonitor Commentary
Experts Panellists: Peter van Wely Head of Inforeach EMEA Peter has over 15 years professional experience focusing on the Capital Markets Trading domain. He has worked with several international organisations from both the buy and sell side. Peter is well versed with the operations of the securities markets and he combines domain knowledge with his client relation and projects expertise. Heading business development in the Capital markets, Peter has been responsible for setting up multiple product development and project development engagements with clients. 15 years ago Peter set up Infopulse Financial Markets in Amsterdam, a company developing trading and connectivity products and delivering IT services and consultancy to the Capital Markets industry.This company was acquired 5 years ago by Cognizant, where Peter became responsible for integration and the Benelux and later went on to head the Capital Markets division for Europe. At Cognizant he grew the Benelux from â‚Ź4 million to â‚Ź17 million turnover in 4 years, with an EBITA of 24%. Peter was responsible in the past for delivering to the AEX Amsterdam, the first open equity trading application and one of the first big OMS systems in the Benelux, followed by various successful automatic trading and connectivity solutions, as well as extensive MiFID engagements in recent years. Next to knowing the European and Indian software development industry, he has set up software developing teams in Rumania, Hungary and the Ukraine. Peter joined Inforeach over a year ago to set up Inforeach Europe and holds a Masters in International Economical Relations and in International Business Law from the University of Groningen (The Netherlands). Peter is married, other than surfing the waves of Capital Markets, he likes to travel, read, be out on the water, and is a committed follower of the Roman God Bacchus.
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Transaction Cost Analysis Q&A ATMonitor Commentary
Editor’s Choice: Selected Questions and Answers from the ‘Transaction Cost Analysis Q&A’ expert panel.
Are transaction costs really important enough to make a difference? Robert Kay, TradingScreen It is generally accepted that transaction costs are of similar order of magnitude to commissions (10-20 b.p.) and in the case of less liquid stocks or very large trades may be as much as ten times commission costs. Even at this level (200 b.p.) the expectation is that price movements over time will dwarf these costs. For that reason some portfolio managers and funds regard transaction costs as relatively unimportant. However, while across a portfolio performance differentials are typically much smaller and as a result a difference in transaction costs represents a meaningful gain in overall alpha generation. It is also important to note that management of transaction costs is unlikely to eliminate them but is capable of helping reduce them.
Should a hedge fund use TCA? If so, why? Michael Sparkes, ITG Hedge funds can benefit from good application of transaction costs analysis just like any other institution. There is clear evidence that the accurate measurement and analysis of implicit costs can identify inefficiencies and biases in trading strategies which can over time have a significant impact on investment returns. Robert Kay, TradingScreen Hedge funds should certainly consider using TCA to improve overall trading performance. While the links between portfolio managers and traders may be closer within a small organisation than a larger tradition asset manager, there are still always going to be opportunities to improve the process based on effective analysis. In any trading situation there are likely to be qualitative factors that any model or analysis cannot fully account for. However, with the advent of more electronic trading and better quality trade and market data the number of factors that are known and can be taken into account is continually growing. As such TCA has become more relevant and appropriate and this will become even more apparent in the future. The strength of the conclusions drawn from any analysis should properly be considered in the context of limitations in the completeness and/or accuracy of data. The fact that not everything is known does not however undermine conclusions that can be made based on data that is available. The fact that one trade may be subject to special circumstances unknown to the analyst does not undermine the conclusions being drawn based on the weight of information about the vast majority of transactions.
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Transaction Cost Analysis Q&A ATMonitor Commentary
What is implementation shortfall and why is it important? Michael Sparkes, ITG You can think of implementation shortfall as the difference between the theoretical cost of a change in a portfolio (which might be assumed to be zero) and the actual outcome. Most frequently this is an implicit cost (the prices paid for the buys will have moved up during the process of buying), but in some cases it can be an implicit gain, if prices on the buys are moving down. In part this is a reflection of market conditions, in part down to the style of portfolio management employed (value versus growth, for example) and in part the skill of the trader and their broker. The measurement of this loss or gain is an important element in monitoring and managing the implementation of investment decisions, which in turn can have a material effect on investment performance.
What specific benchmarks do you expect buy-side managers to use? Robert Kay, TradingScreen There are three common benchmarks used by buy-side traders. First in Implementation shortfall from Release Time (i.e. the time the order or part of it is placed in the market). Some traders may use authorisation time (the time they take control of the order on their blotter from the portfolio manager). Second is Interval Volume Weighted Average Price (IntVWAP) which looks at the performance when they are in the market. Last is reversion (either one hour or half-life) which looks at what happens to prices after the order is completed. Point in time benchmarks are measured against mid quote at the time in question.
What benchmarks do you think pension funds should use? Specifically, in regards to forex? Michael Sparkes, ITG Pension funds, as asset owners, are concerned about investment performance and potential loss of value of their assets. Therefore an implementation shortfall-based approach would appear to be a good starting point for the analysis, adjusted for the nature of the fund (size, geography, etc). Regarding foreign exchange, again it is important to monitor achieved prices versus those seen in the market when they were trading. Implementation shortfall again should be monitored for FX trades to ensure prices are in line with expectations. VWAP-based approaches can also add colour, although market data for asset classes other than equities can offer challenges.
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Transaction Cost Analysis Q&A ATMonitor Commentary
Do you think that TCA which deals with many variables in an attempt to provide standard cost comparison across may asset classes is of benefit to the industry as a whole or only those who sign up for a specific algorithm or methodology? Peter van Wely, Inforeach I think it benefits one more than just a specific algorithm or methodology. Of course your TCA is as good as the data you use and the integration with your EMS/OMS, so a lot of attention should be put there. Next step is to make sure you can also visualise the data in heat maps and graphs for your own use during pre-trade or post-trade, but also intra-day. If you have that integration of not just TCA on one algorithm but really aggregated data in a visualised form, it benefits your trading and your reporting, both internally and to your clients. It also makes it better to judge which strategy, which algorithms and which brokers you will use after your TCA. I guess it also depends in how many asset classes you trade and what the breath of your trading is.
What kinds of normalisation processes are used to make comparisons useful? Robert Kay, TradingScreen Normalisation has to try to reflect the factors that might impact trading costs. So trade size, market liquidity in the stock, volatility of the stock, bid/ask spread, market and momentum would be typically used to make a comparison - whether between brokers, traders or different portfolios. A pre-trade cost estimate seeks to take account of all of these factors, either with reference to historic and/or current market data. The problem is that these estimates are driven by proprietary sophisticated analytical techniques which are hard or impossible to make transparent to the user i.e. a buy-side client. Without transparency, and given the fact that many are produced by brokers and dealers, it is difficult for a buy-side trader to assess the reasonableness and objectivity of the estimates. That in turn affects their overall usefulness as a ‘normalisation’ tool.
What actions can I take based on transaction cost analysis? Robert Kay, TradingScreen Actions fall into three categories; those related to internal relationships with portfolio managers, those associated with counterparty brokers and those to do with the organisation of the trading desk itself. Patterns in portfolio manager trade generation that consistently incur high costs (implementation shortfall) can be highlighted to see if internal communication flows are optimal. Not all brokers are equally proficient at executing different kinds of orders or in different markets.TCA can help identify strengths and weaknesses so that orders can be routed to those best able to handle them. Finally some trades are more difficult to get done at low cost than others and experience can help. So identification of harder orders, where relevant experience has the potential to make a meaningful improvement in performance, can be directed to individuals best able to handle them effectively.
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Transaction Cost Analysis Q&A ATMonitor Commentary
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