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Stocks Are Higher, and So Is the Pressure for Lower Trading Costs

Firms fight market fragmentation with data to find the right liquidity and avoid high-frequency volatility.

Investment managers had plenty of reason for good cheer as they prepared to ring out 2013 and ring in the new year. A buoyant equity market saw the Standard & Poor’s 500 index soar by more than 26 percent as of December 10, to more than 1,800, while the Dow Jones industrial average breached the 16,000 mark late in the year for the first time.

The bull market has improved the fortunes of many managers, but it hasn’t fostered any complacency. Five years after the great financial crisis, demands for greater transparency and accountability in equity trading — and lower costs — are louder than ever.

“In years that you see a nice strong market, typically you don’t hear much about trading costs,” says James Bryson, president of Elkins/McSherry, a subsidiary of State Street Corp. That’s no longer the case, he adds. Transaction cost analysis “is now a part of the trading process — and it’s here to stay,” says Bryson.

Firms are having to sharpen their analytical tools, though. With market fragmentation continuing apace and concern about the impact of high-frequency trading worrying investors, the challenge of delivering best execution is getting tougher all the time.

 U.S. TradingEquity investment managers
RankManagerDifference vs.
Survey Universe in
Basis Points *
1UBS Global Asset Management-25.12
2Deutsche Asset Management-22.45
3Timessquare Capital Management-22.08
4Jennison Associates, LLC-20.60
5Pzena Investment Management, LLC-20.40
6Harris Associates LP-19.94
7GMO, LLC-19.51
8Dreman Value Management, LLC-18.73
9Gamco Investors, Inc.-18.69
10Davis Selected Advisers, LP-18.26
* - Based on full-day volume-weighted average price; data covers the 12 months ended June 30, 2013

Brokers have fought for years to best one another on a cost basis. Today the competition is increasingly focusing on real-time data services, says Bill Foster, executive managing director of Weeden & Co. a Greenwich, Connecticut–based brokerage. Fund managers want specific information about their trades to track broker performance, and more than just the numbers. They want to know how their brokers achieved them.

“As commissions have declined,” says Foster, “there is now less to be squeezed out of the explicit cost side of the equation, so the focus continues to shift to the implicit side” — the cost of getting into or out of a position while the market may be moving against you. Bid-offer spreads have narrowed over the past several years, but market depth has also declined, especially displayed depth, he notes.

 Global TradingEquity investment managers
RankManagerDifference vs.
Survey Universe in
Basis Points *
1Marathon Asset Management-31.16
2Brandes Investment Partners-25.45
3Harris Associates LP-22.53
4Arrowstreet Capital, Limited Partnership-20.43
5Capital Guardian Trust Company-20.15
6Franklin Templeton-19.69
7Mondrian Investment Partners Limited-18.11
8GMO, LLC-16.49
9Acadian Asset Management, LLC-16.28
10Numeric Investors, LLC-16.27
* - Based on full-day volume-weighted average price; data covers the 12 months ended June 30, 2013

Weeden places second among U.S. agency brokerages in Institutional Investor’s latest Transaction Cost Analysis survey, conducted by Elkins/McSherry. The survey compares investment firms’ trading costs relative to the volume-weighted average price, based on a universe of approximately 1,400 managers. Weeden’s costs came in at 20.74 basis points below VWAP, trailing only New York City–based ­Liquidnet. The dark pool operator posted average costs of 25.11 basis points below VWAP, according to the survey.

 Full-Service Brokerages — U.S.
RankManagerDifference vs.
Survey Universe in
Basis Points *
1Cantor Fitzgerald-19.63
2Jefferies & Company Inc.-18.80
3Merlin Securities (A Wells Fargo Company)-18.16
4BMO Capital Markets-17.23
5BTIG-16.73
* - Based on full-day volume-weighted average price; data covers the 12 months ended June 30, 2013

Among asset managers, UBS Global Asset Management topped the list, achieving costs of 25.12 basis points below VWAP, followed by Deutsche Asset & Wealth Management (–22.45) and TimesSquare Capital ­Management (–22.08). Results can be seen in the tables on these pages.

Exchange consolidation has dominated the headlines in 2013. IntercontinentalExchange, the Atlanta-based upstart founded just 12 years ago, completed its $8.2 billion acquisition of the venerable New York Stock Exchange in November. Three months earlier, rivals BATS Global Markets and Direct Edge Holdings announced their own agreement to merge, a deal they expect to close in 2014.

 Full-Service Brokerages — International
RankManagerDifference vs.
Survey Universe in
Basis Points *
1Macquarie Securities-21.39
2Nomura Securities-17.10
3HSBC Securities-11.63
4Raymond James Capital Markets-6.50
5Macquarie Securities-3.55
* - Based on full-day volume-weighted average price; data covers the 12 months ended June 30, 2013

Although those mergers will reduce the number of U.S. stock exchanges, market participants remain as concerned as ever that fragmentation can drive up transaction costs. As a result, they are focusing intently on venue selection in their transaction analysis.

“I think the most important part of that is not which venues you deal with, but how you deal with them,” says Foster. “With fragmentation of the market, 13 — soon to be 12 — exchanges and a plethora of dark pools, you need to have open eyes about the liquidity that’s out there, knowing when to use it and, more importantly, when not to use it.”

Weeden looks to create close partnerships with its clients to better understand what their risk profiles are and why they are buying or selling a stock. A feedback loop follows all executions so Weeden can go back through a trade, with a client, to see how the firm fared and what it can do to improve execution.

Answering those venue questions requires data, of course, and once again market fragmentation poses a challenge. It’s difficult to obtain consistent data from different trading venues, says Jason Lenzo, director of equity and fixed-income trading at Russell Implementation Services, a brokerage arm of Seattle-based Russell Investments. “There’s a massive amount of differentiation,” he says. “Is it internal? Is it on a legacy system? Is it on the cloud? How do we extract it?”

 Agency Brokerages — U.S.
RankManagerDifference vs.
Survey Universe in
Basis Points *
1Liquidnet Inc.-25.11
2Weeden & Co., LP-20.74
3Bloomberg Tradebook-20.29
4Fox River Execution Solutions-20.15
5Agency Trading Group, Inc.-18.85
* - Based on full-day volume-weighted average price; data covers the 12 months ended June 30, 2013

Russell relies on its own internal quantitative research group as well as third-party market analysis to develop models for execution. The firm ensures that every component of a trade is captured and time-stamped to analyze its efficacy.

For top-finisher Liquidnet, venue analysis requests can be more of a checks-and-balances exercise by investment managers seeking to ensure that the firm is on top of its game. “So we provide these types of analytics to our members,” says Akis Georgiou, head of quantitative sales and analysis. “And we not only provide them, but we actually use them to enhance our algorithms and ensure our members get best execution.”

 Agency Brokerages — International
RankManagerDifference vs.
Survey Universe in
Basis Points *
1Sanford C. Bernstein-25.92
2Bloomberg Tradebook-19.99
3Liquidnet Inc.-18.23
4Pavilion Global Markets-15.20
5State Street Bank (SSGM)-3.12
* - Based on full-day volume-weighted average price; data covers the 12 months ended June 30, 2013

Liquidnet, which specializes in providing block-trading services to long-only institutional investors, offers tools to clients to help keep the high-frequency crowd at bay, says Mike Capelli, head of Liquidnet’s algorithmic servicing group.

One tool within some of the firm’s trading algorithms detects the extent and duration that orders are exposed to its liquidity pool. Liquidnet also employs safeguards like a fair-value model, which measures the extent to which a price stays within a fair-value band, to help prevent adverse executions at poor prices; and smart blocks, which adjust execution size to temper the inevitable high-frequency activity.

 Bulge-Bracket Brokerages — U.S.
RankManagerDifference vs.
Survey Universe in
Basis Points *
1UBS-19.17
2Bank Of America Merrill Lynch-17.50
3CSFB-15.66
4Citigroup Inc.-15.57
5JP Morgan-13.82
* - Based on full-day volume-weighted average price; data covers the 12 months ended June 30, 2013

When it comes to trading venues, UBS Global Asset Management wants its brokers to make real-time decisions about the spot with the best execution “because liquidity is dynamic and moves around the market,” says Mike Abellera, the firm’s interim global head of equity trading. “What might be today’s worst venue, on a relative basis, might be tomorrow’s star.”

UBS communicates with its broker-dealers through the Fix Protocol and uses that to find out which venues its brokers are using, whether counterparties are making or taking liquidity and whether any rebates were involved. “If a counterparty was overly concerned with rebates, that would put liquidity and venue toxicity in the backseat, and potentially my overall execution would be inferior,” says Abellera. “And they wouldn’t be getting a lot of business from me in the long run.”

 Bulge-Bracket Brokerages — International
RankManagerDifference vs.
Survey Universe in
Basis Points *
1Citigroup Inc.-24.80
2JP Morgan-20.93
3UBS-19.38
4Morgan Stanley-17.54
5Barclays Capital-17.02
* - Based on full-day volume-weighted average price; data covers the 12 months ended June 30, 2013

It may be more than three years removed, but the infamous “flash crash” of May 6, 2010, has stayed in the minds of investment managers. A report by the Securities and Exchange Commission and the Commodity Futures Trading Commission attributed the sudden market plunge in part to high-frequency traders, whose activity exacerbated the impact of a large trade by mutual fund Waddell & Reed Financial.

“People are trying to understand: If all these bad things are happening in markets but we can’t see them, what tool will allow them to be seen more clearly?” says Russell’s Lenzo.

One such tool is the Market Information Data Analytics System, or Midas. Developed by the Securities and Exchange Commission and ?Tradeworx, a Red Bank, New Jersey–based high-frequency-trading and financial technology firm, Midas aims to provide an abundance of empirical data collected from consolidated tapes and proprietary feeds from equity exchanges. The system collects about one billion records daily from U.S. equity exchanges, according to the SEC’s Midas web site, which was rolled out in a user-friendly format in October. In a market devoid of sophisticated visualization tools, Weeden’s Foster sees Midas as a promising example of technology from which other tools could be derived over time.

“It’s incumbent upon everyone involved in the life cycle of a trade to make sure that the least amount of friction exists,” says Foster.

As regulation seeks to make the markets more transparent, the accumulation and consumption of data will only increase. Trading costs — the pennies on millions of dollars — need to be accounted for. The competition to improve execution looks set to intensify even further in 2014 as the U.S. equity rally matures and the prospect of an exit from the Federal Reserve’s quantitative easing policies threatens to increase market volatility.

“2014 could be a little bit more of a roller coaster, which will make transaction costs even that much more important,” says Foster. “The divergence of strategies between firms and traders will increase.” • •

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