ATMonitor Commentary

July 2011 Issue

Transaction Cost Analysis and Best Execution

10 things you wanted to know about TCA but hesitated to ask

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Transaction Cost Analysis and Best Execution

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 will 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, the Expert Panels on MyATMonitor are 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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Experts Panellists (in the order of appearance):

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 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 degree in Mathematics. Michael Sparkes Managing Consultant, Investment Technology Group Michael Sparkes heads ITGs 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 Morleys 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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Editors Choice: Selected Questions and Answers from Transaction Cost Analysis and Best Execution expert panel.

What can transaction cost analysis tell me that I do not already know?
Robert Kay, TradingScreen In an ideal world every trader knows everything about every trade and the performance of every broker in every market. Unfortunately given the ever increasing complexity of trading and rapidly changing activities and performance of different brokers it is simply not possible for a single trader, however experienced to know everything. TCA can help traders organise, assimilate and utilise massive amounts of information about their trading performance and how internal, market and broker changes are affecting trading outcomes.TCA can also assist in quantifying more accurately the costs being incurred so that models used to create and change portfolios can reflect total costs of turnover.

At a bare minimum, at what frequency should we be reviewing TCA? Is intraday too frequent, quarterly too late?
Robert Kay, TradingScreen Intra-day review is part of the process of managing trades rather than analysing them. Analysis mainly involves a periodic review to determine patterns of outcomes (good or bad) that occur regularly within the trading activity. That might be by trader by broker by market, by size of order and so on. Most clients would expect to do enough trades to observe outcomes every month and this is the most common period over which TCA is used. Michael Sparkes, ITG Historically clients reviewed post-trade data on a monthly or quarterly cycle to observe trends, biases and potential problem areas within their trading. This cyclicality is good for overall management of the process (for instance by head of desk, compliance manager or CIO), but increasingly it is complemented by more frequent analysis - weekly, daily or even intra-day. More frequent or realtime analysis allows the trader to monitor and manage the process in much greater detail, taking information from what has just happened (or happened in the last day or two) as an input to the decision making with regard the tactics to employ in current or planned trades. Hence the different frequencies really address different needs.

How should I consider analysis of different venues where my trades are executed?
Robert Kay, TradingScreen There are two things to consider in respect of venues. First is whether the level of fragmentation of your order(s) and the venues where they are traded are consistent with or different from overall

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market activity and the handling of similar orders by the same or similar brokers. If the pattern of your execution is different then you need to understand why and the extent to which this may be the result of your instructions to brokers or their exercise of discretion in getting your order(s) done. Second is how the prices of individual fills of your orders compare with prices available at the same time on alternative venues. This can be done but involves access to significant amounts of accurately normalised very precisely time-stamped data from your broker. This is time consuming and possibly expensive to analyse on every trade. So logically you would look for anomalous patterns e.g. a lot of your orders being crossed in dark pool(s) and then look at those trades in more detail to confirm you are suffering no disadvantage.

Leaving aside a plain vanilla algorithm that might be straightforward to replicate/check - what might be the best way to attempt to prove that a benchmark calculated by a more sophisticated complex algo is doing what we think it is doing. Are TCA providers able to provide some measure of checking that these algos do what they say on the tin?
Michael Sparkes, ITG Increasingly the measurement of algo effectiveness is an important element of TCA. As per previous answers, the granularity of the data can cause issues of complexity, cost and accuracy/consistency, but it is nevertheless feasible. There are various metrics used to measure algo performance, depending on the objective of the specific algo strategy. This may entail IS, VWAP, participation rates or other factors. Traders are looking to compare the effectiveness of apparently similar algos from different brokers, and this is only possibly by TCA.

Is reversion an important technique? What is the best measure?

Robert Kay, TradingScreen Measuring reversion is increasingly seen as a critical component of TCA analysis. The key is to understand what happened in the market after your trade was finished. If prices revert back to levels better than those at which you traded, then that suggests that there may have been information leakage on the trade (i.e. other people bought in ahead of your buy-order and then sold out as soon as completion of your order had pushed the price up. On the other hand if prices keep rising after your buy-order is finished then that suggests that the pace of your trading was effective in reducing implementation shortfall.There are varying degrees of sophistication in reversion measures. Most use a fixed period (the price 30 or 60 minutes after your order finishes), others use half-life (i.e. if your trade is in the market for 3 hours then you would compare with the price 90 minutes after your execution is finished. Some managers prefer longer periods (such as T+1 Close).

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What is implementation shortfall and why is it important?

Robert Kay, TradingScreen Implementation Shortfall is intended to measure the difference between the average price of an execution and the price prevailing at the time the trade is received by a broker or exchange (arrival time). In electronic trading the arrival time is typically very close to the time at which the order is released by the buy-side trader. Some buy-side firms measure Implementation Shortfall as the difference with the price at the time the buy-side trader received the order. This measure cannot be used to compare brokers, but for some firms it provides an interesting insight into the impact of the own trading practices. In some cases Implementation Shortfall includes commissions and taxes to provide a measure of the difference between the ideal price at which stocks are added to, removed from a portfolio and the actual price achieved by the portfolio. Because it measures the impact on alpha generation of a portfolio manager or buy-side firm resulting from trading it is, for some firms, the key measure of trading effectiveness.

How do different brokers pre-trade estimation tools differ?

Michael Sparkes, ITG Different pre-trade estimation tools vary in a number of ways, but all have in common the objective of attempting to give an indication of likely trading costs (both in terms of potential impact and delay costs) based upon a number of parameters and based on historical patterns. Typically they can be calibrated for different trading strategies. Clearly the forecasts will vary depending on the specific parameters and settings applied, and the database of historic data that they are based upon.While the variation of estimates will be relatively tight for smaller orders in more liquid securities, the range of expected outcomes will be much larger for less liquid trades. Increasingly clients are looking for real-time monitoring of trading costs, so will look to update their strategy using pre-trade tools that can post-trade information on very recent market conditions and trading outcomes.

I have heard people talk about hybrid measures. What are these?
Robert Kay, TradingScreen Most VWAP or TWAP measures are based on a fixed time period, usually the interval during which the order is in the market (i.e. from release time to execution time). A hybrid benchmark measures an average (VWAP or TWAP) but the period is determined based on order size and the percentage of volume that is deemed desirable or appropriate. So if an order is for 50,000 shares and the target volume is 10% this would be called a VWAP10 benchmark. Then the deemed interval would be from release time until such time as 500,000 shares had traded meaning that 50,000 shares would represent 10% of volume. The actual trade may have been done more or less aggressively than this. So if a trader is regularly underperforming VWAP10 it could be because they are too aggressive chasing volume when the stock price is drifting i.e. they could afford to wait, or they are too passive in situations where momentum is adverse i.e. if they

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traded faster they would get done quicker with less slippage. It can also be useful as a proxy to review the effectiveness and potential dealer profit/loss on principal trades.

Does a private bank need TCA to satisfy its Best Execution requirements?
Michael Sparkes, ITG We are finding that an increasing number of private banks (and their clients) understand that the way in which a trade is conducted, and the related transaction costs, can have a significant impact on the profitability of the trade, and the overall success of the investment strategy of the client.While not necessarily essential, TCA is seen by many as an important tool in the broader monitoring of best execution. With regard to the previous question on hybrid benchmarking, another way in which this is evolving is to match the benchmark to the specific requirements of each trade, rather than applying a one-size-fits-all approach. Hence if 90 trades are given to the broker on an implementation shortfall basis, but 5 are to be traded VWAP and 5 are to be traded Market on Close, a hybrid benchmark can be employed to refer the performance of each line item to the relevant metric. It would clearly be misleading if an IS-based analysis was applied to the VWAP and MOC instructions. Aggregated performance can be calculated, but with specific hybrid benchmarks applied to each trade on the basis of the manager or traders instructions.

How do you control what type of clients are in a peer group comparison?
Michael Sparkes, ITG There are at least two important aspects to this. Firstly it is important that data included in any peer analysis is clean and consistent. Hence a TCA vendor has a responsibility to exclude any data for which there are known data limitations (such as the accuracy and comprehensiveness of relevant timestamps). Secondly there is the question of comparing apples to apples - whether by market (US trading is likely to be cheaper than Emerging Markets, other things being equal), type of institution, etc. Historically this has been a challenge, although some vendors have applied filtering techniques at the institutional level to attempt to offer direct peer comparisons. More recently a new approach has been developed which buckets each individual trade with other trades that share the same set of characteristics, and then aggregates these individual situational rankings into an overall performance ranking on a difficultyadjusted basis. This bottom-up approach offers a number of benefits including a true apples-to-apples comparison at the trade level, and it also allows comparison of a clients performance with others in specific market situations. We believe that the trade is the best basis of comparison rather than the type of institution, the size of assets managed, etc.

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About ATMonitor
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