Where Should Thrifty Traders Go for Lowest Transaction Costs?

No one would ever accuse Gateway Investment Advisers of swinging for the fences.

The Cincinnati-based investment firm with $10.38 billion in assets under management shuns a slugging mentality. Instead, it takes the approach of a solid, no-star baseball team that wins games “with singles and doubles while trying to avoid strikeouts,” says Paul Stewart, CIO and co-manager of the firm’s equities fund.

Gateway calls its investment style “hedged equity.” It builds a diversified portfolio of stocks and hedges it in two ways: either by selling index call options (Standard & Poor’s 500 Index options) written at or near the level of the market or by buying outof- the-money S&P index put options. When the S&P 500 roars, Gateway’s $6.7 billion equity fund underperforms, achieving steady but nonetheless “sedate” returns, Stewart says. When the market swoons the fund is protected by the put options. “Long term,” he notes, “we’ve captured 70 percent of S&P returns with 40 percent of the risk.” Short term, though, the fund’s formula lags the market: through November, Gateway’s flagship fund was up only 5.92 percent, versus a 12.6 percent gain for the S&P 500.

One key to making Gateway’s strategy work: Its trading desk casts a cold eye on expenses. “It’s incumbent on us not to have high costs,” Stewart says. “That would be painful.”

The firm’s vigilance earns it a high ranking in Institutional Investor’s most recent Transaction Costs Analysis survey, conducted for the publication by Elkins/McSherry, a division of Boston-based State Street Corp. The survey measures a firm’s trading costs against the average performance of some 1,400 investment managers, relative to the volume-weighted average price. Gateway ranks No. 5 among investment managers in the U.S., with a cost of 20.04 basis points below the Elkins/ McSherry universe average in the 12 months ended June 30. Only four investment firms deliver stronger performance. AJO Partners comes in first place, with an average cost of 33.87 basis points below the universe average, followed by BlackRock (–20.33 basis points), Brandes Investment Partners (–20.13) and GMO (–20.11).

On a global basis, First Eagle Investment Management leads the pack, besting the universe average by 22.30 basis points, followed by Pyramis Global Advisors (–21.07 basis points), Mondrian Investment Partners (–20.25), T. Rowe Price (–16.62) and Thornburg Investment Management (–16.60).

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Among brokerage houses, Redburn Partners is the clear leader of agency brokerages in global markets, with a cost of 49.86 points below the universe average. France’s Exane tops the table of full-service brokerages, with a cost of 37.21 basis points below the average while Deutsche Bank Securities comes first among bulge bracket brokerages (–20.36).

Global Trading Top international equity investment managers, benchmarked against full-day VWAP ¹

U.S. Trading Top U.S. equity investment managers, benchmarked against full-day VWAP ¹

These days, traders do battle in a sobering market environment. Although the U.S. economy has continued to improve since the Great Recession of 2007–’09 and the S&P was up 12.6 percent in 2012 through November, equity trading volume declined 18 percent during that period, according to Raymond Tierney, chief executive of Bloomberg Tradebook. In addition, reports Tierney, U.S. equity options trading skidded by 12 percent and financial futures slumped 10 percent over the same period.

A former global head of equity trading for Morgan Stanley Investment Management, Tierney blames the dispiriting statistics on a “crisis of confidence.” Culprits include the risk of wayward technology, such as the rogue algorithm that led to a $400 million loss at Knight Capital; Nasdaq Stock Market’s botched Facebook initial public offering; and the $5 million fine levied against the New York Stock Exchange for early sharing of information with some high frequency traders.

Full-Service Brokerages Top international equity brokerage firms, benchmarked against interval VWAP ¹

Full-Service Brokerages Top U.S. equity brokerage firms, benchmarked against interval VWAP ¹

In addition, say market participants, investors are restive over the regulatory uncertainty surrounding dark pools — unregulated trading systems that match buyers and sellers in a private marketplace — and upcoming implementation of the Volcker Rule, which will bar banks from conducting proprietary trading. Banks are also scrambling to meet the higher capital requirements mandated by the Basel III global accord. A general malaise stemming from the persistent euro zone crisis is further sidelining investors.

Brokerages especially are struggling as competition continues to compress commissions. According to Elkins/ McSherry, commissions in the U.S. have declined by 0.47 basis point, to 8.41 basis points, compared with a year ago. In addition, ever more sophisticated technology and low-touch algorithmic trading have set off a shakeout of the brokerage sector. Layoffs are rampant, and a growing number of firms are closing up shop. Over the past year the fallen have included Ticonderoga Securities and WJB Capital Group. “For the brokerage industry in general, revenues have been down and costs are up,” says Niamh Alexander, a financial services industry analyst at Keefe, Bruyette & Woods.

In the hopes of not only surviving but finding new synergies, other brokerages are joining forces: In the past year, Wells Fargo Securities acquired Merlin Securities and Raymond James Financial bought Morgan Keegan & Co. from Regions Financial Corp. Other brokerages are branching into research and offering bespoke investment products. They’re hoping to earn extra fees while cementing relationships with investment firms that are keeping a close eye on trading costs. Douglas Dixon, a principal on the trading desk at $20 billion AJO Partners, says trading costs “are especially important because we’re running a value-oriented quant shop.” Like other money managers, AJO benefits from fierce competition among brokerages to win business.

Bob Santella, president of the brokerage group at SunGard’s Fox River Execution Solutions, sees a “flight to quality” by some buy-siders seeking “highperformance providers” and “responsive customer service” at a time when many competitors are downsizing. “Our group’s trading volumes are up about 50 percent over last year” as the firm has added new clients, he says.

Once a brokerage has been retained by the buy side, it can expect to be constantly monitored, assessed and ranked according to what Joseph Scafidi, director of trading at Brandes, the No. 3 manager in the U.S., describes as “multiple performance metrics.” Brandes is loath to select a brokerage only on the basis of its being a lowcost provider; the firm uses traditional full-service, high-touch firms in concert with execution-only firms. “You get what you pay for,” says Scafidi. “There’s real value to the high-touch business and in human interaction. You can’t hide in the weeds and execute according to the lowest explicit costs.” Hightouch traders can help clients steer clear of their “predatory” high frequency counterparts and offer insight into small-cap and emerging-markets names. “Algorithms don’t help you there,” Scafidi says.

Nor are algorithmic trading programs of much use to traders meeting in the increasingly popular dark pools. Rhodri Preece, director of capital markets policy at the CFA Institute, a global investment industry association, reports that over the past three years, “off-exchange trading in undisplayed venues has grown by approximately 50 percent.” Although critics of dark pools argue against their lack of transparency, Preece is a staunch defender as long as “we don’t reach a point where the majority of trading activity takes place away from the ‘lit’ public markets, which is where prices are discovered.”

Backers like dark pools as both a source of liquidity and an end run around high frequency traders that engage in front running, which is both illegal and costly for those left behind. If HFTs get wind that a million shares of a security are being transacted, they may attempt to buy stock ahead of the block-buyer and sell it back to the institutional investor at a higher price, pocketing the difference. Miranda Mizen, director of equities research at Tabb Group, notes that outfoxing the HFTs is increasingly a highstakes proposition. Trading in dark pools is “like a sophisticated game of hide-and-seek. And if you want to see without being seen, you have to have sophisticated technology.”

Agency Brokerages Top international equity brokerage firms, benchmarked against interval VWAP ¹

Agency Brokerages Top U.S. equity brokerage firms, benchmarked against interval VWAP ¹

Even so, as margins tighten on the execution front, brokerages are hunting up ways to leverage their positions. Fox River has partnered with financial services firm Robert W. Baird & Co. to add research capability to the diversified algorithmic trading it offers to institutional investors. With more than 100 analysts, Milwaukee-based Baird has a reputation for “providing premier research on small- and midcap stocks,” reports Santella.

Montreal-based Pavilion Global Markets., No. 4 among global agency brokerages, has worked to stay lean. Says Jamieson Ritchie, director of global markets trading: “We’ve been able to maintain or grow our trading volumes in difficult times. We’ve never overextended ourselves. Some firms have ten investment bankers and a bunch of researchers. With a lot of mouths to feed, those firms are closing down.”

But over the past two years, Pavilion has hired a three-person team of strategists and now offers clients a “global macro strategy research” product. These analysts “focus on all major economies and markets and set strategies on how to invest in equities, bonds, commodities and currencies over the next six to 12 months.” Even though “trading volumes are getting more difficult,” Ritchie adds, “the new product has been a positive catalyst.”

ITG, a leading agency brokerage and financial technology firm, stitched together a research unit, ITG Investment Research, following its acquisition of two regional firms, Majestic Research Corp. and Ross Smith Energy Group. Majestic’s analysts had followed 200 companies in 17 sectors and boasted a loyal following among institutional clients. Ross Smith, a Canadian shop with a 40-person staff, brought along 60 new clients to ITG plus connections to corporations that were the subjects of its analysis. Many of the buy-side firms switched to using ITG for execution of U.S. equity trades, says Ian Domowitz, managing director and head of ITG’s analytics.

Guzman & Co., a boutique brokerage based in South Florida, has tried its hand with research. In the spring of 2000, just before the Nasdaq bubble burst, Guzman hired two analysts to follow cable, media and telecom companies. But in 2007 the firm dropped its research group. As Guzman focuses on its core business, it has expanded into operating a 24-hour international trading desk, adding technology and two new hires, registered to trade in Europe. It also trained its staff to handle global trading duties. “We’ve talked to our clients, and it seems that a lot more of them are investing in emerging markets and putting less into their U.S. portfolios,” says John Bell, vice president and head of global equity trading.

Bulge-Bracket Brokerages Top international equity brokerage firms, benchmarked against interval VWAP ¹

Bulge-Bracket Brokerages Top U.S. equity brokerage firms, benchmarked against interval VWAP ¹

Few brokerages have diversified as rapidly and aggressively as Bloomberg Tradebook as it moves from what CEO Tierney calls an “execution-only model” to an “execution-everything model.”

“We don’t just provide electronic execution services anymore,” says Tierney, “we offer cradle-to-grave services.” The firm has morphed into an emporium offering independent research, commission management and execution consulting, along with its customized algorithms. Using transaction cost analysis, the firm will not only customize an algorithm but keep track of the client’s performance and make whatever changes the product requires to work at optimum levels. In 2011, Bloomberg Tradebook completed more than 65 such projects for 45 clients across equities, options, futures and foreign exchanges.

Even as it rolls out new products and services, the firm has not neglected stock trading. “We think if we help clients reduce transaction costs, we can turn this expertise into market share growth,” says Tierney. The Bloomberg executive started his career as a Paine Webber trader in 1981, and he knows the abiding value of Wall Street’s bread-and-butter business. • •