As if a nasty bear market isn’t taxing enough for stock investors, terrorism and extraordinary volatility are making it more expensive to execute trades.
By Justin Schack
November 2001
Institutional Investor Magazine
The terrorist attacks of September 11 continue to wreak havoc on Wall Street, far beyond the physical and human toll taken that awful day in lower Manhattan. On trading desks around the world, brokers and money managers must now struggle with exceptionally volatile stock markets, fueled by the uncertainty surrounding military engagements in Central Asia, biological warfare and the prospect of further terror attacks.
Increased volatility has been the disorder of the day in recent years. But of late the swings have been extraordinary, even for stocks like Cisco Systems that are used to seeing heavy action on most days. On October 17 positive earnings projections from the company’s CEO sent the shares on a wild, 33 percent intraday swing; midmonth they traversed an 11 percent range. Far more typical was the 6 percent range its shares rode on September 10. General Electric Co. shares covered a 14 percent range on September 21 and 11 percent two days earlier, compared with only 3 percent the day before the attacks.
These roller-coaster rides have become the norm, not the exception, and not only in the U.S. One-year rolling volatility rose significantly during September and October for both the Standard & Poor’s 500 index of U.S. stocks and the FTSE 100 index of blue-chip European shares, according to Morgan Stanley’s Quantitative Strategies Group. The rolling volatility figure measures how much each index can be expected to vary within a one-year period, based on an analysis of trailing one-year prices. For the S&P 500, this volatility rose from 21.7 percent in August to 23.6 percent in October; the FTSE 100 jumped from 18.4 percent to 23.9 percent. Both October figures are nearly double those of a decade ago (see graph below).
“It’s a very treacherous environment. Intraday volatility has never been higher,” says Andrew Brooks, head of trading at $167 billion-in-assets mutual fund complex T. Rowe Price Associates. “Add the nervousness in the environment, post-September 11, and it’s only getting worse.”
For investors, this has meant a nasty double whammy. Not only did portfolios plunge in the wake of the tech wreck and a weakening global economy, but soaring volatility also began to make it more expensive to execute trades. The bottom line: The more a stock moves during a trading session, the more difficult it is to execute trades at desired prices.
“Transaction costs very easily can bleed a percentage point or two from a portfolio manager’s returns,” says Paul Davis, co-head of quantitative portfolio management and trading at CREF Investments, a division of $270 billion pension fund TIAA-CREF. “That can mean everything. It can be the difference between beating the market and not beating the market.” And not beating the market can mean losing assets to competitors who do.
Institutions have contended with this deteriorating environment for several years. Throughout the 1990s they focused on ways to minimize costs, from asking brokerages to position large blocks with their own capital - a relatively old technique - to experimenting with a host of electronic systems as alternatives to the exchange floor and broker’s desk. Markets around the world have done the same. Especially in Europe, many abandoned physical trading floors for more efficient electronic platforms.
Until recently, efforts to control costs worked quite well. The average cost of executing a trade declined from 73.2 basis points to 59.6 basis points from 1996 to 1998, according to Elkins/McSherry Co., a New York brokerage and trading consulting firm. Costs rose modestly overall in 1999, to 60.84 basis points, but several major markets, particularly in Europe, continued to post declines. Elkins/McSherry’s latest annual study of global transaction costs for this magazine, which used data from 2000, shows another small increase in overall costs globally, to 61.18 basis points.
However, the most recent data for individual major markets show far more significant spikes. Costs rose 16 percent for New York Stock Exchange-listed issues, 9 percent for Nasdaq stocks, 27 percent on sell orders in the U.K. (buy orders carry a “stamp duty” of 50 basis points and thus are a less reliable indicator), 36 percent in France and 14 percent in Italy. Overall, the cheapest market in the world is Japan, where costs declined in 2000 from 25.07 to 22.06 basis points. The NYSE had held that distinction for two years running, but has fallen to third in the latest survey. The Paris Bourse, which was the world’s least expensive market in 1996 and 1997 before falling behind the Big Board, now stands ninth. The Netherlands, at 23.82 basis points, ranks second behind Japan. Germany, where costs held relatively steady compared with other major markets, finishes fourth, while the American Stock Exchange rounds out the top five.
(see table in pdf format: )
More disturbing for institutional traders, “market impact” costs, which are the most difficult to control, often soared by even larger margins: 40 percent on the NYSE and a stunning 67 percent in the U.K. Market impact measures how large orders in the market affect the price movement of a particular stock. Knowledge of a big sell order in the market, for instance, typically causes other traders to reduce their bids, forcing the seller to get less for his money. Methods for measuring this effect vary, but Elkins/McSherry compares the price at which a trade is executed with the average of the stock’s high, low, opening and closing prices for the same session.
A number of factors underlie cost increases last year. Increased competition for order flow among exchanges and alternative systems such as Instinet Corp. and Island ECN has fragmented trading, while consolidation among asset managers means that firms have far larger pools of assets under management and need to take ever-larger positions in individual stocks. These are simply harder to trade.
But the biggest factor is stock price volatility, which makes it harder for traders to execute orders at the best possible prices. This global phenomenon has become far more pronounced lately. The S&P 500 and FTSE 100 have grown far more volatile from late 1998 to the present than they were for much of the 1990s, according to Morgan Stanley.
“In extremely volatile markets, the opportunity costs of executing trades at certain times increase exponentially,” says Benn Steil, an economist at the Council on Foreign Relations who has studied market structure and transaction costs extensively. “It just makes it a lot harder to get things done. Period,” says Harold Bradley, former head of trading at American Century Investments, who now oversees the $85 billion asset manager’s investments in alternative trading technologies.
Of course, judgment calls and opportunity costs exist in every market. But what may be making the extraordinary volatility of the past two years worse is that it coincides with a sharp sell-off. “Every study I’ve ever seen that split up buy and sell orders found that sells are empirically more costly,” says Ian Domowitz, manager of electronic markets at New York brokerage ITG, which operates the popular Posit crossing network. “No one really knows why. But intuitively, in down markets, people are dumping, and they give a lot less thought to how they are dumping than to how they buy.”
Considering all these factors, traders speculate that transaction costs have continued to rise throughout 2001 and will keep going higher in the near future. With a prolonged U.S. military response and further terrorist action possible, a return to more normal levels appears a long way off. If anything, a greater degree of uncertainty could mean that even more drastic price swings lie in store.
T. Rowe Price’s Brooks believes that the greater volatility is in part an unintended consequence of narrower trading increments and the rise of electronic communications networks, or ECNs, both of which have made it easier for smaller investors to move markets and caused sharper price swings because of smaller trades. "[Volatility] has been escalating since we went from eighths to sixteenths, sixteenths to decimals,” Brooks says. “Spreads are down, but your execution is not necessarily better.”
For some people, though, a little volatility is a good thing. Proprietary trading desks at major brokerage houses, for one, attempt to capitalize on fast-moving markets by betting their own money on the short-term direction of stocks. Derivatives traders and hedge funds often pursue similar strategies. The pressure to step up this kind of activity will be especially strong at securities firms that, even before September 11, were reeling from one of the deepest slowdowns in decades for the brokerage and investment banking businesses. Will they shrink from aggressively trading their own accounts for fear of being labeled war profiteers? Don’t bet on it. “The president, the mayor, everybody says we’ve got to get back to normal,” says one senior trader at a major brokerage house. “Well, we are in the business of making money and maximizing shareholder value. That’s our normal. If the markets present us with an opportunity, we are not going to pass it up.”
But for the vast majority of institutional investors, volatile markets mean higher transaction costs. So what’s to be done? Not much, according to traders. Says TIAA-CREF’s Davis, “You just have to keep doing what you do every day to try to keep costs down, because the volatility is essentially something you can’t control.”
One strategy for minimizing transaction costs has been attempting to meet or beat cost-efficient execution benchmarks, such as the volume-weighted average price. This measurement calculates an average price for a given stock during a trading session, giving more weight to prices at which large quantities of shares trade. It has become the holy grail for many institutions, particularly in Europe and Asia. Some traders, however, say that the widespread popularity of VWAP has diminished its effectiveness.
“When everyone is shooting for VWAP, it creates an environment where you never really want to trade your full size,” says Michael Cormack, a former American Century trader who is now president of Archipelago, an ECN for matching stock orders. “If I have 100,000 shares of a particular stock to buy through the day and my benchmark is VWAP, I’m never going to buy the 100,000 around the open, even if the price looks great, because all kinds of things can happen through the day. There’s no incentive to take the risk and say, ‘I think the market’s going to do better today, so I’ll buy my shares now.’ If the market does go up that day, a guy who takes little bites all the way up isn’t doing as well as someone who bought it all early on, but he’s being evaluated on VWAP, so he gets a pat on the back. The guy who does a big chunk right away gets yelled at. Would you rather be wrong by $1 or miss the VWAP by 2 cents? The more traders are benchmarked to VWAP, the less liquidity there will be in the marketplace at a given time.”
Another popular technique since the mid-1990s has been the use of electronic matching systems as alternatives to the broker’s desk or exchange floor, which offer no guarantee that a money manager’s identity and intentions will remain a secret to the rest of the market. One of the more promising of these new systems is Liquidnet, which was launched in April by electronic trading pioneer Seth Merrin. Liquidnet is designed exclusively for institutions that want to find counterparties for large blocks of stock without breaking their orders into tiny pieces - and without using the chatty brokerage community. “We like it because size is meeting size,” says TIAA-CREF’s Davis. “We don’t have to break it up into 50 different tranches and feed it out into the market and take the consequence of that action. Very often the largest block traded in a particular stock on a given day is traded on Liquidnet. Right now it’s another tool in the quiver. But I think it could very well grow into a very important alternative marketplace for institutions.”
While some traders believe that ECNs are fragmenting trading across too many market centers, making it more difficult to execute large transactions, others are successfully using them to minimize costs. American Century now does about 14 percent of its trading in NYSE-listed stocks on alternative trading systems. Bradley, long a proponent of electronic trading, says using these systems has brought transaction costs down more than enough to justify their operating costs. “We are doing more and more of our listed business on ECNs. We found that by doing our most difficult Nasdaq business on ECNs, we were able to take structural risk out of the market,” he says.
If the clear impact of reducing transaction costs on fund performance doesn’t grab money management firms’ attention, the threat of regulatory sanctions and legal liability should. Securities and Exchange Commission officials have advised buy-side officials that they have an obligation to achieve quality trade executions for the pension funds and individual investors that entrust investment managers with their assets.
Over the past several months, SEC examiners have begun asking investment firm officials how they go about attaining the best-quality executions possible. Among the requirements examiners are looking for: regular meetings (at least quarterly) of specific committees designated to evaluate and monitor execution practices, with visible support from senior management; evidence that a firm is seriously considering a wide variety of brokerage firms and alternative systems, rather than simply maintaining time-honored relationships; establishing specific criteria for selecting brokerages and evaluating executions, including whether brokerages minimize market impact when handling large trades; documentation of brokerage review and decision-making processes; and disclosure of execution practices and policies to the public in plain English.
Institutions appear to be adjusting quickly. “We have always had oversight in this area,” says TIAA-CREF’s Davis. “Now we are making it much more formal. Not only will it meet the SEC objectives, but it will help us meet our objective of lowering trading costs.”
The SEC clearly believes that, bear market and high volatility or not, institutions could be doing better for their clients in terms of keeping trade execution costs down. That is difficult to argue with. Sell-offs and wild price swings may be beyond traders’ control. But with the cost analysis tools and execution technology available today, sending orders where they are most likely to be executed cheaply most definitely is not.
Table: How the top brokerage firms and investment managers rank in execution costs around the world
(see in pdf format: )
Calculating trading costs
The Elkins/McSherry Co. analysis measures total trading cost, which consists of execution commissions and fees, added to a calculation of trading effectiveness called “market impact.” Market impact is the difference between the price at which a stock trade is executed and the average of that stock’s high, low, opening and closing prices during the day.
Elkins/McSherry ranks countries and exchanges by aggregating the total trading costs of all of their stocks. Individual brokerage house and money manager rankings measure the amount by which the firm’s average total trading cost beats that of the market or country as a whole.
