State Street researchers look to attack market impact losses

State Street Global Markets is developing a system to reduce the two largest costs associated with portfolio transitions – market impact and opportunity cost – while at the same time producing new research to show how its off-market trading reduces the other ‘implicit’ costs.

At the annual State Street Global Markets client conference in Sydney yesterday, the company released an analysis conducted by its research affiliate, State Street Associates, which showed that off-market trading of securities was conducted at only 25 per cent of the cost of traditional market trading. The analysis was based on transitions for about $US1 trillion in assets over 3,000 transition events. Justin Balogh, head of transition management in Asia Pacific, said the analysis, using one of the largest available data sets in the world, provided “a clear and quantifiable insight” into the real benefits of off-market trading and accessing alternative sources of liquidity. A major source of liquidity for State Street is its funds management arm’s index funds, however, Balogh said that about two-thirds of the transition management business did not touch the other arms of State Street. While the analysis should not surprise industry participants, given that internal crossings avoid broker commissions and bid/ask spreads, State Street also gave the conference a sample of how the larger costs associated with transitions – opportunity cost and market impact – can also be reduced. State Street has been researching since early last year the application of an algorithm which will allow for continual optimisation of transitions by taking a risk-management approach to the process. Sebastien Page, managing director of State Street Associates in Cambridge, said work was now being done on the complicated IT component. He was hopeful it would be available for clients to use by the end of next year. “As we trade the sensitivity of trades changes. So we break up the trades,” Page said. The algorithm allows the transition manager to rank each pair of trades and rank them according to their impact. Some trades, or parts of trades, will reduce risk in the portfolio faster than others. For example, the transition manager may have all the proposed trades ranked in terms of impact and then transacts, say, 5 per cent of one of the buy/sell orders, at which point in time, the ranking may change. To buy or sell the next 5 per cent may impact more on the portfolio, so that proposed trade moves down the ranking. The system will work in a fashion similar to that of an optimiser used in efficient portfolio construction. In a graphic illustration, the trades will look like an efficient frontier. The system will work for all trades – not just those crossed internally. According to the research, market impact and opportunity cost (due to time) will be reduced by 40 per cent. “This is the next generation of transition management,” Page said.