8/14/2019 Drifting Icebergs: Perceptions and Reality in Trading Costs

1/2

9rorrIDCOMMENTARY 68 ocToBER 2001

DRIFTING ICEBERGS; PERCEPTIONS AND REALITY IN TRADI/VG COSISA recent survey concluded that market academics believed the markets were improved by regulatorychanges while traders felt the opposite. Who is more correct? Surprisingty, both, but in different dimensions.

Has Market Quality Deteriorated?Late last year, Bob Schwartz and Dan Weavs surveyed bothbuyside/sellside practitioners and academics for their cunentperceptions of market quality. The key issue was whether regulatorychanges that reduced spreads and increased aress to markets hadimproved market effciency. The academics viewed the changesfavorably;however, both buyside and sellside traders were lessenthusiastic. While the 'new market' may be friendlier to the retailinvestor, the overwhelming perception was that regulations have ledto higher msts and more difficult trading conditions for Institutions.ls perception reality? The trade/s views were shaped by acombination of increased volatility, market fragmentation, and heavierorderflow as assets exploded while the market soared and dipped.But is more difficult trading the'fault'of the market? Moreover, is thenew market truly more expensive?Reality: Lower Cosfs

Years ago Plexus introduced the use of an iceberg to describeexecution msts. At the tip was commission, easily seen but relativelyinsignificant. Market lmpact (Brokerage)was the next layer; moresignificant, but still small relative to what lay under the water. Plexusmeasures lmpact as the difference between the release pnce and theaverage execution pnce on the trade day. The hidden msts lie in themultiday Timing and Opporlunity categories as institutional traderssearch for, and sometimes never find, liquidity.Tlischaft below shows iceberg data fur ieca fquarteis;Lsing iire1999 average as a reference. Here we focus on execution costs andomit Opportunity effect, which will be discussed later.

Large and Small Cap Trading Costs since 1999 l"o"Larse caps Smatt caps : IiJ'

.oe Cr""t.d" r"""."$ nouo ."tt ""s"gs rr"t ^dPlexus data shows that costs remain flat for Large Cap and haverecently fallen for Small Cap after peaking in the Summer of 2000.This is contrary to perception, or is it? We note that Schwartz andWeaver conducted their survey shortly after costs, especially SmallCap, rose to their all time high.Brokerage msts (lmpact, shown in red) rose for both Large and Small

250200150100

500

Cap trades. lmpact costs include spreads; yet the total is rising ethough spreads are shrinking. The nse in lmpact was accompanby a fall in multiday delay msts. This anomaly hints that the naturthe trading has shifted the cost structure in ways unrelated to maprocedures. We shall see that these changes blur perceptiontrading costs. In the next few sections we will show that: 'l) Tradbecame more concentrated; 2) Momentum conditions lightenicadng io ic;v.vered rcsts; and 3) The ffight to safety shifted institutitrading focus from small cap stocks to lower-cost large caps.

More Concentrated TradingThe table shows that the increase in lmpact results from an increin very large daily trades exceeding 250,000 shares:. The percentage of very large trades soared, accompanied btendency to concentrate heavy trading under the control of a sinbroker, especially in NASDAQ trades. Increasingly, traderc are ubrokers to search out liquidity wherever it can be found.. lmpact mst for large trades increased even more signifcantly. Cofor small trades may be shrinking, but that is a moot pointI nstitutions : ov er 7 5o/o of the daily trades by ou r clients results forders exceeding 50,000 shares.

Sizeand 1mp-act aione do not teJithe wl-oie stoi-y. Price i-nonrenduring trading represents the greatest challenge for traders sincethe most impoftant determinant of cost. The percentage of ordencountering adverse momentum conditions dropped 3 percentapoints for both Large and Small Cap funds, to 25% and 3respectively. This three percentage point drop leads to a 15% dromomentum trading costs. This drop was partially offset by redugains from trading orders in Favorable market conditions.Gosf of Standardized Trades

We've shown that shifting trading emphasis accounts for most ofdrop in msts, but the question remains: have costs dropped, or nPlexus reestimates its benchmak mst equations each quarter, uthe previous six months of trading data. Thus any shifts in trade mstructure will be reflected in changes in the mst equations.The next two graphs compare quarterly benchmark costsstandardized Large and Small Cap stocks, having the followcharacteristics typical of institutional trades:

One Day Trades Are Larger - And More Expensive!NYSE % Chanqe NASDAO %Chang% of Total Activitv 20 35Q2001 41 39

1 999 u 29Averaqe lmpact 42 228Q2001 _?7 hh

1 999 -26 bp -29 bp

8/14/2019 Drifting Icebergs: Perceptions and Reality in Trading Costs

2/2

oJ(9ulo-

ooJ(9ulo-

The graphs show expected costs for 0% (red) and far 4okmomentum (yellow), The cost figures are the average cfNYSflNASDAQ equations for both buy and sell o de sStandardized Benchmark eosts - Large Cap

This reinfnrces or:r helieJthat clients are bemming more attuned tothe eost of delays and cancellations. De-emphasizing low brokerlmpaet in exchange for lower Timing and Opportunity costs has likelyled to higlrer eaptured returns as well as lower total costs.Canclusions

Traders rjisprute the claim that new market regulations improvedmarket uuality" F:rorn the Institution's viewpoint, lower costs at thei"etail !e.;ei ha.re led to mirch higher costs for institutional size.Flexus ieebergs show fairly rnnstant Large Cap trading costs since1899. and Snrall Cap stockstrending cheaper. Both of thesefindinps arc cr:ntrary to irader perceptions.This at-a-glarrce perception may be too facile. lt appears thatresJrictror:-q !n Small Cap tracling costs primarily reflect changes inorder clrar;rctenstirs The icetrerg may not look so favorable had theperrei rtaqe nf A.dverse Momenhrrn orders not dropped off.A trend lnwards higher broker lmpact suppotls the traders'argrrment" Shi"inking spreads have ied to increased premiums forsiz,e. ln:nicaily, traders are responding by trading more aggressively,leading ta larger intra-day volr.imes. They can fincl liquidity, and theo';er"all speed *f trading as measured by daily completion rates hasnot riropped. In exchange for controlling Timing costs, traders arewilling to pay r:p fnr mpirl fill of lsvgs orelers.Tt'ris is a su*t:essful strategy when urgency is high, and leads tolower trtal eosts. But as Lrrgency drops, we do not see acornnrensuiate drop in lmpact" Consequently, the total cost ofneutral Srnall Cap orders remains high. In contrast, neutral Largeeap orcjere show litlle drift from histonc averagesVlle believe that this reflects the changes in market regulations.Smalier cap stoeks have greater sensitivity to retail traders.improved aricess to markets and lower spreads have provided smalltraders wifh an opportunity to crowcl in front of Institutional sizedorders, whieh pay lrigher premiums to access size. At least in thissectar of the market, reducing costs for the little guy may truly beshifting the i.'rrils tr,rthe hig; Institutiernal guy.

Plexus Graup Reschedules Conferenceln response to the tragic evenfs of Sepfembe r 11th. Plexus Grouprescheduled its canference at Amelia lsland to February 24-27, 2002.We invite your aftendance.ln honor af our clients, fiends and acquaintances whose lives were ',tragicalty tost, Plexus Group has made a cantibutiontothe FredAlger Families Trust.

Reprint any poftian with credit given to:

250204150100

5U0

Large Cap costs initially fell in '1999, and did not start to nse until latein the year, After peaking in early 2000. costs fell hack and are nr.ncrbelow the historic average.

Standardized Benchmark eosts - Small eap250204150100

500

Similarly, Small Cap trade costs forAdverse momentum orders fellof later in 2000, but the cost for neutral momentum remains highPerhaps earlier high-momentum costs were distorted by theNASDAQ bubble and then reverted backto more normal levels. Webelieve. however. that recommendations to Plexus clients to trademore aggressively into momentum to avoid delay costs alsocontributed to the shift. "Normal" momentLrm cersts outside of thisself-selected universe may be much higher.Completion Rates Remain High

Because the PAEG/L and the iceber_os reflect only traded shares,these results may be affected by traders and managers who cancelorderc rather than pay up. We tested this hypothesis by compadngcompletion rates and unexecuted retums for those clients providingcomplete order information.

Opportunity Cost bp

2000 1001 1999tr Large Cap tr Small eap

The left side of the graph shows that completion rates have held up.Both the Large Cap and the Small Cap funds now show slightlyhigher mmpletion rates despite larger orders and increased volatility.One result of higher completion rates is lower Opportunity costs forthe Large Cap funds, and steady costs for the Small eaps.

M grorrp1 1 1 5A W. Olynpic Blvd., l#ffi Los Angeles, CA 9m64

PH: 31 0. 31 2. 5505 FAX: 31 0.31 2.55A0 vwwu.plexusgroup.com.:..:.:'..:..:...::.:.:..:::.:::..:::.:]:].:.:] :]]::]:.::::]:

Pre 99 1999 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01

Pre 99 1999 1Q00 2Q00 3Q00 4000 1Q01 2Q0t

Completion Rates Are Holding UpCompletion Rate