Yossi Brandes and Ian Domowitz, Managing Directors at ITG ask what can multi-asset TCA learn from the equity experience?(Photos L to R: Y. Brandes, I. Domowitz)
Lessons learned and things to forget
The movement of transaction cost analysis (TCA) into futures, FX, and fixed income instruments is largely powered by experience with equities. The experience is limited. Five years ago, only 28 percent of institutional desks employed TCA on a daily basis, although the number is now 68 percent and growing.(1) As late as 2010, the main use of equity TCA was for compliance purposes. One year later, survey results across 408 institutions globally suggest that two-thirds of institutions place the responsibility for trading cost performance and improvement squarely with the desk.(2)
TCA faces an obvious challenge – to proactively lower transaction costs by helping managers and traders construct portfolios and leverage implementation strategies using imperfect information. Equity TCA is no longer relegated to forensics. Nor is it about the predictability of cost for any particular order.
TCA is about insulating trading and portfolio performance from changes in market conditions, by providing information which leads to intelligent strategy choices and the ability to change them. This is the first lesson, and it applies to all tradable financial instruments.
A second lesson comes from survey results. As early as 2008, 40 percent of survey participants suggest that alpha is lost primarily through trading costs, with timing (a major component of costs) accounting for 14 percent of respondents.(3) TCA is all about investment returns, not about achieving an average price. This lesson was taught as early as 1981.(4) Some examples might help make the point in the current environment.
We examine the relative return of approximately 160 emerging market funds in Figure 1. Data are arranged by quartile, with the relevant return along the vertical axis in the dark bars.
The average return in the first quartile is 5.56 percent, while the average in the second quartile is 1.81 percent. The average cost for an order in our emerging market universe (the lighter bars) is 74 basis points (bps). The first quartile of funds lose 13 percent of their return to transaction costs while the second quartile loses 41 percent. In a high volatility environment, 26 percent of average return is lost to implementation for the best funds, while a whopping 79% of the relative return disappears in the second quartile.(5) A mere 11 bps of return separate the best fund in the second quartile and the worst fund in the first quartile. A modest improvement in the implementation process moves a fund from the second to the first quartile.
Other examples come directly from buy- side traders and portfolio managers. Robeco Investment Management reports a saving of 20 bps by combining TCA with portfolio management style analysis.(6) Principal Global Investors make a strong case that TCA should be part of pre-trade, post-trade, and trade monitoring, with numbers illustrating an 86 bps return to the exercise.(7)
Another way of phrasing this lesson from equity TCA is, it’s all about the money and potential savings are large. That message translates directly into other asset classes. An examination of FX trading, linked to global equity transactions, suggests that poor execution can cost the average large institution roughly $40 million per year, a three-fold increase over implementation which uses TCA to identify liquidity supply in the market.(8)
There are other common lessons, and things to be unlearned as TCA moves to disparate financial instruments. We begin with market structure.
The biggest single change in equity markets over the last fifteen years is the empowerment of the buy-side trading desk. Desks are expected to add value, as opposed to simply facilitating the implementation of investment choices. Traders are looking for control, and the motivation is efficient and inexpensive execution. One outcome is the demand for TCA services. Interest extends beyondforensics, to tools permitting a proactive approach to the cost issue.
Control requires accurate measurement. This lesson applies directly to other asset classes. Interest in futures TCA is coming from trading desks, which link futures and equities in their implementation strategies. As interest in control increases, so does the demand for TCA. Consolidation of trading desks is part of the story in fixed income, following a separation of trading and portfolio management. In FX, there is a movement away from custodial execution to proactive management of currency trading. Some interesting tales revolving around such activity are told by Eastspring Investments Singapore and AXA Investment Managers.(9)
Buy-side control cannot be separated from the movement to electronic market structure, which permits self-directed trading and presents headaches in the form of fragmentation across time, destinations, and geographies. The headaches also are a driver of TCA.
The electronic revolution in equities is well- established. Futures trading received a large electronic boost during the late ‘80s and early ‘90s. During that period, 28 new derivatives exchanges were built around the world; 26 were fully electronic. This movie is coming to a market near you, with a recent round of electronic fixed income venues, and a strong move in FX to electronic trading.(10)
The benefits and drawbacks of electronic market structure drive TCA and the nature of its tools. This lesson is becoming more important over time. A survey by Greenwich Associates suggests that 25 to 30 percent of institutional clients in the UK and Continental Europe already use some form of TCA for fixed income. Fixed income TCA is prevalent only in 17 percent of US institutions, in a country which (perhaps surprisingly) has historically lagged with respect to electronic markets. On the FX side, among the world’s institutions, which manage greater than $20 billion in assets, 41 percent of institutions that employ TCA use it in their FX investment process.(11) This development is linked in our minds to a 65 percent utilisation rate, by volume, of electronic execution in the FX market.
Sophisticated analytics are great, but comprehensive data are the life blood of TCA. The equities world has all but forgotten about data availability issues. Need market data on some small stock in a tiny market? No problem. Need buy-side transaction data for a granular analysis of strategies in Latin America? Just bypass the order management system and go directly to the network FIX connections or execution management system. Good data are critical, but all you need to do is pay up for it, in cash or development resources.
Except for some exchange-traded instruments, forget the second part of this lesson in the context of other asset classes, at least for the near future.
Publication of indicative prices in FX is routine, but access to tradable quotes with good time stamps is market-by-market, bank-by-bank. Our understanding from the field is that most FX TCA providers rely on a combination of indicative quotes and one, possibly two, providers of actionable information. We have spent considerable time and resources to compile a tick-based order book from twelve major banks and five ECNs, and can say that it was a heavy (and expensive) lift. A TCA provider must virtually replicate an exchange in terms of market data, in order to perform the simplest of tasks.
The experience with time-stamped buy- side data has not been any easier. Despite the construction of custom extraction tools, the data are, well…a mess, requiring a great deal of work. Custodial data are easier, of course, but lack a variety of information, not the least of which is the time when the executions occur. TCA is about timing and tagging of information, and custodial data leave much to be desired.
Fixed income is marginally better, and to the extent that it is, there have been tangible advantages to the market. The establishment of the US TRACE system in 2002 brought transparency into the corporate bond market. In 2010, trade data on debt issued by federal government agencies were incorporated. TRACE appears to reduce investors’ cost significantly, supporting a transparent pricing regime.(12) In Europe, regulatory mandates currently limit transparency rules to instruments admitted to trading on regulated exchanges. They do not apply to OTC markets, where the majority of fixed income trading takes place. Similar comments apply to other regulatory jurisdictions around the world. The situation appears worse, when one considers the large number of bonds which can be characterised as off-the-run. TCA for fixed income will rely in part, as dealers do, on prices generated from a matrix.
The advance of electronic trading in FX and fixed income, as well as the “futurisation of swaps” envisioned as part of the outcome of swaps execution facilities, will ameliorate the situation. Execution management systems are becoming multi-asset capable, which enables granular data with good time-stamps. We look forward to those developments.
Usage and tools
Compliance is the easiest market for TCA vendors. Equity TCA is learning a difficult lesson over time, as the focus shifts to trading and portfolio performance: post-trade TCA is a performance attribution exercise, in which a variety of factors require isolation to judge a particular implementation strategy and pinpoint the “own” impact of an order. An entire book could be written on this topic.(13) The analogy is portfolio performance attribution, where a goal is to isolate the manager’s contribution to returns.
This lesson must be quickly absorbed, as one considers other asset classes. Compliance remains an issue, given changes in regulatory mandates for the OTC markets. The focus on performance is virtually immediate, however. That focus took years to develop in equities. In contrast, based on a survey by Greenwich Associates commissioned by ITG, 92 percent of respondents cite investment process improvement for FX as a driver of TCA adoption.
The drive to actionable measurement is manifested in part by a virtual obsession with child algorithmic trading orders and millisecond granularity of data. The movement also follows from a narrowing of the definition of ‘best execution’ as pursued by buy-side trading desks, in light of practical circumstances, market structure evolution, and uncertainty as to what best execution really means. At the level of the trading desk, pre-trade and post-trade TCA are now employed for analysis of order routing, venue-type selection, and strategy performance. The effective goal of such work is the verification of best price in the face of liquidity and momentum conditions.
Best execution reverts to best price at the level of the trader. Best execution may not immediately translate to best price for the investment process, represented more clearly through the parent order. The difference generates the next lesson.
TCA cannot afford to ignore upstream technology in the form of order management systems, execution management systems, and managed financial networks. For example, Greenwich Associates isolates a critique related to the trade/order distinction, consisting of a failure of systems integration relevant to data flows.(14) The issue is a lack of linkage between EMS and OMS systems. The OMS provides order-level data. The EMS and the managed financial network deliver placement and strategy information. Data from the network or EMS often constitute child orders relative to the parent residing in the OMS. How does one learn about the parent by studying only the children? They are only reflections of strategy.
As TCA moves away from equities, and as market structure evolves, this issue is binding. Obsession over fragmented child orders must be reconciled without glossing over the portfolio of trading strategies used to execute the parent. Self-directed trading in FX, futures, and fixed income is spawning a new generation of EMS and revisions to FIX protocols for the network. Novel extraction utilities are yet to be built out to their fullest possible extent. That responsibility rests with TCA providers.
Pre-trade analysis and post-trade reporting
The separation of pre-trade and post-trade analysis has a long history, with the former based on market data and the latter combining such data with buy-side transactions. This separation is incompatible with a lesson reflecting the drive towards performance.
Actionable information requires the transformation of TCA reporting into decision support tools. This may seem obvious, but examination of many reporting formats might convince you otherwise.
A different perspective on TCA takes shape, if one abandons the dividing line between post-trade historical analysis and pre-trade strategy selection and monitoring. Moving from reports to decision support requires the delivery of information from post- trade performance data to pre-trade tools, based on the blotter’s orders and tuned to decision making. An order’s characteristics are enhanced by performance information given current market conditions. This permits broker evaluation, strategy analysis, the determination of optimal broker packages, and the like. From the perspective of post-trade TCA, we move from T+1 to real time. Viewed from the pre-trade side, market data are complemented by information based on execution history.
Is anybody listening?
In their 2011 study of TCA, Greenwich Associates present what they term, “a thoughtful and powerful critique of TCA.” They present this critique using quotations from survey respondents, of which the following stands out: “More non-traders are looking at [TCA] and this is a very bad thing.” There is a lesson here, but first, a question: bad for whom, and why are TCA results not being explained by those who trade to those who don’t? This ‘thoughtful’ critique disparages a class of real and concerned consumers of TCA information, including buy-side boards of directors.
If one takes the quote as a lesson, it is one of those to forget. It does provide a stepping stone to an important point for multi-asset TCA.
Develop a narrative, avoid a blizzard of numbers, and use language appropriate to the audience. Things are bad enough in equities, with hundreds of ‘named’ benchmarks and jargon to fill the gaps between pages of numerical information and graphs. We are entering worlds in which ‘duration’ joins price in fixed income benchmarking, ‘pips’ become delimiters, USD.TRY is a noun, and ‘rolls’ represent behaviour. Equity TCA has let a thousand flowers bloom with respect to presentation and terminology, without pruning them in such a way as to be widely understood. Lack of understanding and communication undermines any move into other asset classes.
TCA providers must communicate better, but they need help from their constituents. To this end, we applaud the efforts of FIX Protocol groups, led by Mike Caffi of State Street Global Advisors and Mike Napper, from Credit Suisse. They recognise concerns that inconsistency in TCA terminology across providers presents practitioners with challenges. A consolidated glossary is being developed, and as of this writing, groups devoted to TCA for FX, for Fixed Income, and for futures/ listed options are being created.
This last lesson may be the most important of all. ■
1. Tabb Equity Report for 2012/2013, The Tabb Group. 2. “TCA: Taking the Next Step,” Greenwich Associates, 2011,
which also discusses the 2010 results. 3. “Imperfect Knowledge: International Perspective on
Transaction Costs,” Tabb Group, 2008. 4. J. Treynor, “What Does It Take to Win the Trading Game?”
Financial Analyst Journal, 1981. 5. Average cost in this scenario is 142 bps. 6. “Saving 20 bps and a Lot of Time,” GlobalTrading, Q3 2013. 7. “Integrating TCA,” GlobalTrading, Q1 2013. 8. “How Big is ‘Big?’ Some Evidence from Aggregate Trading
Costs in the FX Market,” this volume. 9. See “Transforming FX Through TCA,” GlobalTrading Q3 2013. 10. Statistics and references are provided in “How Big is ‘Big?’
Some Evidence from Aggregate Trading Costs in the FX
Market,” this volume. 11. “Transaction Cost Analysis: Into FX and Beyond,” Greenwich
Associates, Q3 2012. 12. Corporate Bond Market Transparency and Transaction Costs,
by Amy Edwards, Lawrence Harris, and Michael Piwowar, Journal of Finance, June 2007; Market Transparency, Liquidity Externalities, and Institutional Trading Costs in Corporate Bonds by Hendrik Bessembinder, William Maxwell, and Kumar Venkataraman, Journal of Financial Economics, November 2006.
13. One does exist, although admittedly it does not cover very recent developments. See Below the Waterline, ITG, 2009, available upon request.
14. “TCA: Taking the Next Step,” Greenwich Associates, 2011.
© 2013 Investment Technology Group, Inc. All rights reserved. Not to be reproduced or retransmitted without permission. 91613-17027
These materials are for informational purposes only, and are not intended to be used for trading or investment purposes or as an offer to sell or the solicitation of an offer to buy any security or financial product. The information contained herein has been taken from trade and statistical services and other sources we deem reliable but we do not represent that such information is accurate or complete and it should not be relied upon as such. No guarantee or warranty is made as to the reasonableness of the assumptions or the accuracy of the models or market data used by ITG or the actual results that may be achieved. These materials do not provide any form of advice (investment, tax or legal). ITG Inc is not a registered investment adviser and does not provide investment advice or recommendations to buy or sell securities, to hire any investment adviser or to pursue any investment or trading strategy. The positions taken in this document reflect the judgment of the individual author(s) and are not necessarily those of ITG.
©Best Execution 2013