Global agency brokerage and technology firm ITG has launched a new publication investigating challenges and developments in the analysis of trading costs. CLARE ROWSELL, head of client relationship management for ITG in Asia Pacific, argues that transaction cost analysis has become a vital tool for funds managers and traders, and looks at how new advances can help reduce costs and improve performance for investors.
“The easiest route to the top quartile of performance is to be in the bottom quartile of expense”– Jack Bogle, investment expert and founder of Vanguard. According to an independent study by TABB group, 98 per cent of large institutions and 88 per cent of mediumsized institutions in the US use posttrade transaction cost analysis (TCA). Regulation in both the US (Reg NMS) and Europe (MiFID) mandates the measurement of trading costs as an important component of best execution – ie trading in the most efficient way to maximise portfolio value and minimise costs. In Australia the concept has been recommended by IFSA and is quickly gaining support amongst fund managers and super funds. So why is TCA so important, and how does it help? Fund performance isn’t only about finding the best stocks to generate returns, it’s also about buying and selling them in a cost effective way.
If you get it right your fund can benefit from major savings, but get it wrong and your fund’s performance can slip. The costs of trading are important not only because of the difference they make to the overall amount of money in the portfolio and the return to the end investor, but also because they are one of the few areas that investment firms can exert some control over, irrespective of the frequent ups and downs of the market. There are essentially two types of trading cost. The first are most obvious – explicit or visible costs such as brokerage fees and taxes, which tend to be easy to measure. The second are implicit or ‘hidden’ costs lurking below the waterline. These hidden costs, generally categorised as either market impact or delay costs, can best be identified by measuring the difference between the price at the time the investment decision is made, and the price at the point of execution.
For institutional investors these hidden costs are normally far more significant than the more obvious commission charges (see chart below). TCA is the analysis of large volumes of trading data to identify where and how costs are arising, both in terms of broad trends and individual occurrences of good or bad execution performance. Data can be analysed by portfolio, market, executing broker, individual trader, right down to looking at individual ‘outlier’ trades. There are a number of key benchmarks that measure how well trades are executed in absolute terms, versus the anticipated cost, or compared to the market average.