Portfolio: Execution

The investment process has been described as a three legged stool supported equally by securities research, portfolio management and securities trading.

Buy-side traders are professional traders employed by investment manager or institution investors who place the trades that execute the decision of portfolio managers (quickly, without errors and with favorable price.

Market microstructure: the market structures and processes that affect how manager’s interest in buying and selling an asset is translated into execute trades.

Order types:

- A market order: is an instruction to execute an order promptly in the public market at the best price available. A market order emphasizes immediacy execution. (price uncertainty)

- A limit order: is an instruction to trade at the best price but only if the price is at least as good as the limit price specified in the order. A market order emphasizes price. (execution uncertainty)

- Market not held order:

Types of Markets:

- Liquidity: the ability to trade without delay at relatively low cost and in relatively large quantities.

- Transparency: availability of timely and accurate market and trade information.- Assurity of completion: trade settle without problems under all market conditions.- Trade settlement: involves the buyer’s payment for the asset purchased and the transfer of

formal ownership of this asset.

In what follows, we describe the chief ways trading is organized:

- Quote-driven (or dealer) markets, in which members of public trade with dealers rather than directly with one another.

- Order -driven markets, in which members of the public trade with one another without the intermediation of dealers.

- Brokered markets, in which the trader relies on a broker to find the other side of a desired trade.

Quote-driven (Dealers) market:

Quote driven markets rely on dealers to establish firm prices at which securities can be bought or sold.

A dealer sometimes referred to as a market makers.

Note: the quantity associated with the bid/ask price is often referred to as the bid/ask size.

Example:

Dealer A: bid 98.85 for 600 shares; ask 100.51 for 1,000 shares.

Dealer B: bid 98.84 for 500 shares; ask 100.55 for 500 shares.

Dealer C: bid 98.82 for 700 shares; ask 100.49 for 800 shares.

Limit order. The inside bid, or market bid, which is the highest and best bid: 98.85 from dealer A. The inside ask, or market ask, which is the lowest and best ask from dealer C: 100.49. The inside quote, or market quote -> 98.85-100.49. Market spread = 1.64. Midquote (halfway between the market bid and ask prices) = 99.67

However, in some markets, it is also possible for the trader to direct the buy order to a specific dealer (reliable, as one example, currency markets are dealer markets, and institution active in those markets may screen counterparties on credit criteria.

Dealer have played important roles in bond and equity markets because dealers can help market operate continuously (being ready to take the opposite side of a trade). Dealers also play important roles in markets requiring negotiation of the terms of the instrument, such as forward markets and swap markets, where otherwise finding a counterparty to the instrument would often not be feasible.

The effective spread is 2 times the deviation of the actual execution price from the midpoint of the market quote at the time an order is entered. The effective spread is a better representation of the true cost of a round-trip transaction because it captures both price improvement and the tendency for the large orders to move price (market impact)

Notes: if the effective spread is less than the market bid-asked spread. It indicates good trade execution or a liquid security. More formally:

Effective spread for a buy order = 2 x (execution price – midquote)

Effective spread for a sell order = 2 x (midquote – execution price)

Effective spread is a better measure of the effective round trip cost (buy and sell) of a transaction than the quoted bid-asked spread. Effective spread reflects both price improvement (some trades are executed at better than the bid-asked quote) and price/market impact (other trades are done outside the bid-asked quote).

The price improvement has resulted in an effective spread that is lower than the quoted spread.

The average effective spread is the mean effective spread (sometimes dollar weighted) over all transactions in the stock in the period under study. The average effective spread attempts to measure the liquidity of a security’s market.

Example: The effective spread of an illiquid stock

The average effective spread

The share volume – weighted effective spread

In the first trade, there was a price improvement because shares were sold at a price above the bid price. Therefore, the effective spread is less than the quoted spread.

Empirical research confirms that the effective bid-ask spreads are lower in higher volume securities because dealers can achieve faster turnaround in inventory, which reduces their risk. Market makers are not simply passive providers of immediacy but must also take an active role in price setting to rapidly turn over inventory without accumulating significant positions on one side of the market.

Order-driven markets:

Order-driven markets are markets in which transaction prices are established by public limit orders to buy or sell a security at specified prices. Such markets feature trades btw public investors, usually without intermediation by designated dealers (market makers)There might be more competition for orders, but it is also possible that a trader might be delayed in executing a trade or be unable to execute it because a dealer with an inventory of the security is not present.

Electronic Crossing Networks: are markets in which buy and sell orders are batched (accumulated) and crossed at a specific point in time. Crossing networks serve mainly institutional investors.

Advantages: avoid the costs of dealer services (the bid-ask spread), the effects a large order can have on execution prices, and information leakage.

Disadvantages: crossing participants cannot be guaranteed that their trades will find an opposing match: the volume in a crossing system is determined by the smallest quantity submitted.

The market bid and ask prices of the stock: $30.1 and $30.16

Total volume is 7,000 shares and the execution price is at the midquote = 30.13

Crossing networks provide no price discovery (transaction prices adjust to equilibrate supply and demand). Because the crossing network did not provide price discovery, price could not adjust upward to uncover additional selling interest and fully satisfy trader A’s demand to buy.

Auction market-> provide price discovery.

Many order-driven markets are auction markets- that is, markets in which the order of multiple buyers compete for execution.

- Periodic auction markets/batch auction markets (where multilateral trading occurs at a single price at a prespecified point in time). Examples: the open of close of some stock exchange and the reopening of the Tokyo Stock Exchange after the midday lunch break; at these times, orders are aggregated for execution at a single price.

- Continuous auction markets (where orders can be executed at any time during the trading day).

Automated Auctions (Electronic Limit-Order Markets)-> provide price discovery.

These are computer-based auctions that operate continuously within the day using a specified set of rules to execute orders. Example: Electronic communication networks (ECNs) such as the NYSE, Arca Exchange in US.

Automated auctions have been among the fastest growing segments in equity trading. In an ECN, it can be difficult to distinguish btw participants who are regulated, professional dealers and other participants, who, in effect, are also attempting to earn spread profits by providing liquidity.

Brokered Markets:

Refers specifically to markets in which transactions are largely effected through a search-brokerage mechanism away from the public markets (difficult to find liquidity in size)

A block order is an order to sell or buy in a quantity that is large relative to the liquidity ordinarily available from dealers in the security or in the other markets.

Hybrid markets: combine features of quote-driven, order driven and brokered markets.

The roles of brokers and dealers.

A broker is an agent of the investor. In return for a commission, the broker provides various execution services:

- Representing the order: The broker’s primary task is to represent the order to the market. - Finding the opposite side of a trade. Often this service requires that the broker act as a dealer

and actively buy and sell shares for the broker’s own account. The broker/dealer not bear risk without compensation (high cost)

- Supplying market information: - Provide discretion and secrecy: A trader may not want others to know their identity.- Providing other supporting investment services: financing for the use of leverage, record

keeping, cash management, and safekeeping of securities.- Supporting the market mechanism: assures the continuance of the needed market facilities.

Notes: the relationship btw the trader and a dealer is essentially adversarial. Holding trade volume constant, a dealer gains by wider bid-ask spreads while the trader gains by narrower bid-ask spread.

Evaluating Market Quality:

Markets are organized to provide liquidity, transparency and assurity of completion. In details, a liquid market has the following characteristics:

- The market has relatively low bid-ask spreads (Investors can trade positions without excessive loss of value)

- The market is deep. Depth means that big trades tend not to cause large price movements.- The market is resilient. A market is resilent if any discrepancies btw market price and intrinsic

value tend to be small and corrected quickly.

The great advantage of market liquidity is that traders and investors can trade rapidly without a major impact on price. Liquidity adds value to the companies whose securities trade on the exchange.

Many factors contribute to make a market liquid:

- Many buyers and sellers.- Diversity of opinion, information, and investment needs among market participants.- Convenience: readily accessible physical location, electronic platform.- Market integrity:

Example: Lower quoted/effective spread -> improvement in market quality. Effective spreads are a more accurate measure of trading costs than quoted spreads.

A decline in quoted depths reduced liquidity supply.

The costs of trading:

Trading costs can be thought of as having 2 major components:

Explicit costs: direct costs of trading, such as broker commission costs, taxes, stamp duties, and fee paid to exchanges.

Implicit costs:

- Bid-ask spread.- Market impact (or price impact) is the effect of the trade on transaction prices.

Example: suppose a large sell order hits the market and a portion of it get filled at $43.00. Before the rest of it can be filled, the security price falls $0.1 to $ 42.9, so the rest of the order is filled at lower bid.

- Missed trade opportunity costs (or unrealized profit/loss) arise from the failure to execute a trade in a timely manner.Example: suppose a trader places a 1-day limit buy order at $50.00 for a security when the ask price is 50.04. The price rises and the order is left unfilled. If the security closes at $50.01, then the trader has lost out on these profit. The opportunity cost is $0.06.

- Delay costs arise from the inability to complete the desired trade immediately due to its size and the liquidity of markets.

Volume-Weighted Average Price (VWAP): Implicit costs are measured using some benchmark, such as the midquote used to calculate the effective spread. An alternative is the VWAP (weighted average of execution prices during a day)

It allows the fund sponsor to identify when it transacted at a higher or lower price than the security’s average trade price during the day.

For example, if a buy order for 500 shares was executed at $157.25 and the VWAP for the stock for the day was $156.00, the estimated implicit cost of the order would be $650.

Disadvantages:

VWAP is less informative for trades that represent a large fraction of volume. In the extreme, if a single trading desk were responsible for all the buys in the security during the day, the desk’s average price would equal VWAP => does not provide useful information.

Broker with sufficient discretion can try to “game” this measure (to take advantage of a weakness in the measure, so that the value of the measure may be misleading). For example, if the price has been moving down, only execute buy transactions which will be at prices below VWAP. If prices are moving up for the day, only execute sales. ???

Implementation shortfall: is defined as the difference between the money return on a notional or paper portfolio in which positions are established at the prevailing price when the decision to trade is made and the actual portfolio’s return. The methods takes into account not only explicit trading costs, but also the implicit costs, which are often significant for large orders.

The decision price (arrival price/strike price) is the market price of the security at the time the decision to trade is made. It can also be called the original benchmark price.

Implementation shortfall can be analyzed into 4 components:

- Explicit costs, including commissions, taxes and fees. - Realized profit/loss, reflecting the price movement from the decision price to the execution

price for the part of the trade executed on the day it is placed.- Delay costs (slippage), reflecting change in price over the day an order is placed when the order

is nor executed that day.- Missed trade opportunity cost (unrealized profit/loss), reflecting the price difference btw trade

cancellation price and the original benchmark price (decision price)

Example:

- The paper portfolio traded 1,000 shares on Tuesday at $10.00 per share. The return on this portfolio when the order is canceled after the close on Wednesday is the value of the 1,000 shares, now worth 1,000 x 10.08 = 10,080, less the cost of 10,000, for a net gain of 80.

- The real portfolio contains 700 shares (now worth 700 x 10.08 = 7.056)- The cost of this portfolio is 700 x 10.07 = 7.049, plus 14 in the commission and fees, for a total

cost of 7,063.- Thus, the total net gain on this portfolio = 7,056 – 7,063 = -7

The implementation short fall is the return on the paper portfolio minus the return on the actual portfolio = 80- - (7) = 87. More commonly, the shortfall is 87/10,000 = 87 basis points.

We can break this implementation shortfall down further:Commissions and fees = 14/10,000 = 0.14% Realized profit/loss = 700 x (10.07- 10.05) / 10,000 = 0.14%Delay costs = 700 x (10.05 – 10.00)/ 10,000 = 0.35%Missed trade opportunity cost = 300 x (10.08 – 10.00)/10,000 = 0.24%Implementation cost = 0.14% + 0.14% + 0.35% + 0.24% = 0.87% or 87 basis point.

Practice:

The paper portfolio: = (20.09 – 20) x 1,000 = 90The real portfolio = (20.09 – 20.06) x 800 – 18 = 6The implementation cost = 90 – 6 = 84The implementation shortfall = 84/(20 x 1,000) = 42 basis point.

Commissions and fees = 18/20,000 = 9bspRealized gain/loss = 800 x (20.06 – 20.05)/20,000 = 4bsp Delay cost = 800 x (20.05 – 20)/20,000 = 20bspOpportunity cost = 200 x (20.09 – 20)/20,000 = 9bspImplementation cost = 42bsp.

In this example, shortfall was positive, but this will not always be the case, especially if the effect of the return on the market is removed. The market model is E (Ri )=α i+β i E ¿)

In practice, with daily return, α i will be often very close to = 0. With β i = 1, the predicted return on shares would be 1% and the market-adjusted implementation shortfall would be = 0.87% - 1% = -0.13%.

Notes: the application of a benchmark price based on trading cost measures, including implementation shortfall, VWAP (Volume Weighted Average Price), and effective spread.

Examples: A good deal of attention has focused on the use of commissions to buy services other than executive services- that is, a practice known as soft dollar. Many investment managers have traditionally allocated their clients’ brokerage business to buy research services that aid portfolio management.

Transactions costs can be thought of as an iceberg, with the commission being the tip most visible above the water’s surface. The trading costs for large-capitalization and micro capitalization stocks are very different. The least visible component – delay costs – were the largest component of trading costs, especially for micro-capitalization stocks. (69% - micro-capitalization, 44% large-capitalization) For both, commission accounts only about 17% of total costs.

Pre-trade Analysis: Econometric Models for Costs:

The theory of market microstructure suggest that trading costs are systematically related to certain factors:

- Stock liquidity characteristics (e.g, market capitalization, price level, trading frequency, volume, index membership, bid-ask spread)

- Risk (e.g, the volatility of the stock’s return)- Trading size relative to available liquidity (e.g, order size divided by average daily volume)- Momentum (e.g, it is more costly to buy in an up market than in the down market)- Trading style (e.g, more aggressive styles using market orders should be associated with higher

costs than more passive style using limit orders)

For example, expected return = pretrade cost estimate x 2 = roundtrip transaction cost

Types of traders and their preferred order types:

The success of the investment strategy depends on whether the information content of the decision process is sufficient relative to the costs of executing this strategy, including trading costs.

The keystone of the buy-side trader’s choice of trading strategy is the urgency of the trade(the importance of certainty of execution).

The crucial of function of the trading desk is to achieve the best-price trade-off for the impending transaction given current market conditions and security trading behaviors.

The types of traders:

Information-motivated traders: trade on information that has limited value if not quickly acted upon. Accordingly, they often stress liquidity and speed of execution over securing a better price.

Information traders often trade in large blocks (they seek to maximize the value of information)

Value-motivated traders act on value judgments based on careful, sometimes painstaking research. They trade only when the price moves into their value range. They trade infrequently and are motivated only by price and value. Value motivated traders are ready to be patient to secure a better price.

Liquidity-motivated traders.: do no transact to reap profit from an information advantage of the securities involved. (transact to convert securities to cash or relocate their portfolio from cash). They utilize market orders and trades on ECNs.

Passive traders: acting on behalf or passive or index fund pm, seek liquidity in their rebalancing transactions, but they are much more concerned with the cost of trading. They tend to use time-insensitive techniques in the hope of exchanging a lack of urgency for lower-cost execution.

Dealers, whose profits depend on earning bid-ask spreads, have short trading time horizons.

The classification ò traders is relevant to both equity markets and fixed-income markets.

Traders’ selection of order types:

Information-motivated traders: believe that they need to trade immediately and often trade large quantities in specific names. They may use fast action principal trades. By transacting with a dealers, the buy side trader quickly secures execution at a guaranteed price (market orders)

Value-motivated traders: develop an independent assessment of value and wait for market prices to move into the range of assessment (limit orders)

Liquidity-motivated traders: The commitment or release of cash is the primary objective of liquidity motivated traders (market, market not held, best efforts, participate, principle traders, portfolio trades, and orders on ECNs and crossing networks)

Passive traders: Low-cost trading is a strong motivation of passive traders, even though they are liquidity-motivated in their portfolio-rebalancing operation (favor limit orders, portfolio trades and crossing networks).

Trade execution decisions and tactics:

1. Decisions related to the handling of a trade: Good trading lowers transaction costs and improve investment performance. Considerations that come into play:

- Small, liquidity oriented trades can be packaged up and executed via direct market access and algorithmic trading.

- Large, information-laden trades demand immediate skilled attention. Senior traders are needed to manage the tradeoff btw impact and delay costs.

- In addition to best execution, the traders must be cognizant of client trading restrictions, cash balances, and brokerage allocations.

Notes:

Algorithmic trading is the use of automated, quantitative systems that utilize trading rules, benchmarks, and constraints (automatic)

Purposes: to execute orders with minimal risk and costs. The use of algorithmic trading often involves breaking a large trade into smaller pieces to accommodate normal market flow and minimize market impact.

- Logical participation strategies:o Simple participation strategies: seek to trade with market flow so as to not become

overly noticeable to market and to minimize market impact. VWAP (volume weighted average price) the order up over the course of a day so

as to equal or outperform the day’s VWAP. At the beginning of the day, trading later in the day is uncertain, so VWAP for last periods is predicted using historical data or models.

In time-weighted average price (TWAP), is a particularly simple variant that assumes a flat volume profile and trades in proportion to time. The participation

strategy trades at a constant fraction of volume, attempting to blend in with market volumes.

In the percent of volume strategy, in which trading takes place in proportion to overall market volume (5-20%) until the order is completed.

o Implementation shortfall strategies: minimize trading costs as defined by the implementation shortfall measure or total execution cost. Because opportunity costs result from non-trading, this strategy trades heavier early in the day to ensure order completion.

Best execution:

- Best execution cannot be judged independently of the investment decision. A strategy might have high trading costs, but that alone does not mean the strategy should not be pursued as long as it generates the intended value.

- Best execution cannot be known with certainty ex ante (before the fact)- Best execution can only be assessed ex post. Over time and multiple trades, those costs can be

used to indicate the quality of execution.- Relationships and practices are integral to best execution.

Evaluating trading procedures:

- Processes- Disclosures- Record keeping.