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Stealth alpha

How are money managers boosting returns in a sideways market? They are slashing their transaction costs by taking control of trading away from mainstream brokerages.

Money managers have rarely looked to their trading desks as a source of investment returns. Quite the opposite. Buy-side traders were typically an afterthought in the investment process, which was driven by shrewd analysts and portfolio managers picking attractive stocks and then hoping that a Wall Street brokerage would be able to buy a big block before the price moved against them.

So much for history. Faced with a stock market that's going sideways after three years of wrenching declines -- interrupted by 2003's rally -- money management houses have woken up to the fact that the costs of implementing their best ideas eat directly into their returns. After years of benign neglect, they have become fanatical penny-pinchers, integrating their trading desks into their investment processes and hiring more-sophisticated in-house traders, who are taking more control of their orders than ever before. Traders are pressing their sell-side counterparts for cheaper per-share commission rates and using a variety of transaction-cost analysis tools to hold their brokers' feet to the fire. Increasingly, they are using an expanding array of alternative execution strategies to minimize harder-to-quantify costs like market impact. Every cent counts that much more now that the outlook for stock market gains has plunged from 20 percent per year in the 1990s to the high single digits going forward.

"Buy-side traders now think of themselves almost as alpha generators," says David Brooks, director of global trading for Boston Co. Asset Management. "They are better able to understand where they incur costs and where they can really add value to portfolios."

Big brokerage houses can't help but notice the change. "Clients have raised the bar for our trading floor," says Douglas DeMartin, New York­based co-head of the global investor client group at Merrill, Lynch & Co. "We now have more direct contact with buy-side traders than we have ever had."

This transformation of the buy-side trader from glorified order clerk to an integral part of the investment team is upsetting the established order of business on Wall Street. And there's one overriding reason why: In many cases the bulge-bracket brokerage firms that traditionally dominated trading simply aren't the most efficient. Rather than focus purely on minimizing costs, these firms offer an array of capabilities, such as committing capital when clients urgently need to move big blocks and providing nonexecution services like research. But the firms that save institutions the most money on trading costs tend to be execution-only boutiques, computerized exchanges and trading systems that use sophisticated algorithms to break block orders into tiny pieces and route them among various market centers. Increasingly, investors are turning to these alternate systems to execute even complex orders.

This simple but market-shaking fact is amply borne out in Institutional Investor's eighth annual survey of global equity execution costs, conducted by New York transaction-cost analysis firm Elkins/McSherry. Upstart and alternative firms dominate the ranks of the lowest-cost brokerages doing business on both the New York Stock Exchange and the Nasdaq Stock Market.

On the NYSE no traditional bulge-bracket firm cracks the top ten low-cost execution firms. The winner is LaBranche Financial Services, the upstairs trading arm of the giant floor-specialist firm, which beats the average execution cost of all Big Board brokers by 29.6 basis points (see table, opposite). The rest of the top NYSE firms include execution-only brokerages M.J. Whitman, Boston Institutional Services, Guzman & Co. and Instinet; electronic systems Liquidnet and B-Trade Services (a unit of Bloomberg); and NYSE direct-access floor brokerage Griswold & Co. Old-line trading powerhouse Goldman, Sachs & Co. makes the top ten only indirectly, through a seventh-place finish by Spear, Leeds & Kellogg, a subsidiary that offers a popular algorithmic trading engine called Rediplus. Many of the same alternative firms dominate the Nasdaq trading rankings. Meanwhile, the traditional bulge-bracket firms that do show up in the Nasdaq rankings are those that have also developed sophisticated low-touch systems, including Morgan Stanley and Credit Suisse First Boston.

In 1997, the first year that Elkins/McSherry surveyed costs for II, traditional firms like J.P. Morgan; Salomon Brothers; Morgan Stanley; Donaldson, Lufkin & Jenrette; and Goldman dominated the rankings, taking nine of the top ten NYSE slots and seven of the top ten Nasdaq rankings. As recently as in 2000 there were still five old-line firms among the top ten NYSE brokerages and seven again in the Nasdaq top ten.

The migration of orders to alternative venues is helping to bring down costs for all institutions. According to Elkins/McSherry, the average institutional trade globally cost 47.35 basis points to execute during 2003 (see table, page 90). That's down 12.7 percent from 2002, and is the lowest level since Elkins/McSherry began measuring costs for II.

The picture gets even better when looking at more recent trading. During the 12 months ended June 30, global execution costs were a bit lower, at 46.95 basis points. But investors buying and selling U.S. stocks have seen a more dramatic improvement. The average trade of a NYSE-listed issue cost institutional investors 29.00 basis points in 2003, down slightly from 29.30 in 2002. But in the 12 months ended in June, that figure dropped to 25.87 basis points, 11.7 percent lower than in 2002. The cost of a Nasdaq trade fell from 40.36 basis points in 2002 to 38.87 in 2003 and still further to 34.50 in the most recent 12-month period, for a total decline of 14.5 percent. (Elkins/McSherry, a unit of State Street Corp., measures transaction cost as the total of commissions, fees and market impact, which it defines as the difference between a trade's execution price and the volume-weighted average price of the stock during execution.)

"The fact that more buy-side firms are adding execution-only brokers and electronic networks to their broker lists is definitely having an impact on costs," says James Bryson, a senior managing director at Elkins/McSherry.

Overseas markets present a mixed picture. In the U.K. the cost of selling stock has declined by a healthy 19.1 percent, to 25.53 basis points, from 2002 through the 12 months ended June 30. But buying shares in the U.K. has become slightly more expensive, ticking up by 2.1 percent over the same period. (Buys are subject to a 50 basis-point government tax and are thus measured separately from sells.) France and Italy have seen declines of 11.0 percent and 5.9 percent, respectively. But Germany bucks the trend, with costs rising 6.8 percent, to 32.17 basis points, from 2002 through the 12 months ended June 30. The least costly market in the world is Japan, where mostly electronic trading yielded an average cost per trade of only 20.57 basis points.

Many of the factors causing U.S. institutions to squeeze brokers to reduce costs -- and direct orders elsewhere, if necessary -- are also present in Europe and other markets, but to varying degrees. Balky markets are the norm pretty much everywhere, for example. But an additional prod for U.S. institutions -- scrutiny from regulators that want to ensure that fund managers choose brokers on the basis of best execution rather than just to pay for research, access to IPOs or distribution of their investment products -- while very strong in the U.K., is less of an issue on the Continent.

Regardless of where in the world they reside, most institutions seem to be catching on to the fact that costs matter. Where and how a trade is executed can mean the difference between a manager beating his benchmark or underperforming -- and watching assets flow out the door.

"If you execute a trade the right way for a buy-side client, you're really adding alpha for them," says David Barse, CEO of M.J. Whitman, an agency brokerage founded by noted value investor Martin Whitman in 1974, before he started the Third Avenue Management fund company. "If you can pick up 100 or 200 basis points for somebody -- especially in a year like this, when you might only be up by 300 or 400 basis points -- that alpha means a lot."