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.
TCA takes hold in Australia A focus on controlling costs given recent market conditions has kick-started a new wave of adoption of TCA in the Australian and Asian markets, and the benefits quickly become clear. An analysis of costs for trading Australian equities over the past year illustrates how volatile market conditions have resulted in a wide variation in the cost of an ‘average’ trade. In dollar value terms: the average cost of trading a basket of ASX equities went from 43 basis points (bps) in July 2008 to 119 bps in November 2008 at the height of market volatility – an increase of 176 per cent.
Therefore each time a fund manager traded a US$5 million basket of Australian equities, the average cost may have been approximately $59,500 in November 2008 compared to only $21,500 in July 2008 – an increase of over $38,000 every time. This variation is not at the level of the visible commissions, which have remained relatively stable, but at the level of the hidden costs, which are directly affected by factors such as market turnover and bid/ask spreads. Most interestingly, in addition to the rising cost of an ‘average’ trade, greater market volatility resulted in the standard deviation of costs soaring – i.e. the more volatile the market, the more the likelihood of a trade being an ‘outlier’ incurring costs far from the average.
Understanding how much trading is actually costing has rarely been more important, and TCA can help managers and traders identify and control costs in the context of these market conditions. The future of TCA – incorporating results into the investment process Taken in isolation, TCA is a useful tool to measure costs and trading performance after the fact. However, where it adds real value is when the results are incorporated into ongoing trading processes in a cycle of continuous improvement. TCA can provide meaningful information and analysis throughout the investment process that can be acted upon to make informed strategy choices in the face of different market conditions. • The data can be factored into bespoke pre-trade modelling tools to gauge anticipated costs and review investment decisions in light of those likely costs.
For example, if a stock is likely to be very costly to buy in terms of trading cost due to market conditions, can it be replaced in the portfolio by a different stock with similar investment characteristics but lower trading/ acquisition costs? • Workflow can be changed to improve processes. For example, delays in compliance approval processes on investment decisions can result in significant cost impact which, when identified, can be addressed. • Trading tools, whether they be broker desks, algorithms or alternative trading venues, can be monitored to quantitatively identify their value and allow selection of best of breed providers.
TCA is ultimately about insulating trading performance from changes in market conditions by providing information that leads to smart strategy choices and informed execution. Investment performance reflects two factors: the underlying investment strategy of the fund manager and the execution costs involved in realising those objectives. By taking transaction costs into account during portfolio construction, fund managers can achieve greater diversification, lower turnover, and better overall returns. TCA is a vital tool both for traders to understand and control the costs of execution, and for managers to understand the impact of these costs on the performance of their portfolios. By bringing hidden costs from below the waterline to the surface, investment firms are in a position to make better and more informed investment and trading decisions, with the ultimate goal of improving performance for funds and their end investors.
To receive a free copy of ‘Below the Waterline’ please email [email protected] and quote the reference ‘I&T Magazine’.