2. For more information please contact your
Instinet Group representative or visit us
online at www.instinetgroup.com.
3. 1
INTRODUCTION
Transaction costs can be a significant part of the expenses incurred by an investment manager
implementing its investment strategies, and a drag on the performance of its assets. Every dollar spent
on executing a strategy — both in brokerage commissions and hidden trading costs — is a dollar lost to
the plan’s participants; in fact, more than a dollar once foregone returns are considered. Plan sponsors
have traditionally left the problem of transaction costs to their investment managers — and with good
reason. Asset managers are "prudent experts" — a fiduciary with expertise in the field, bound to the best
interests of the plan, and who can make informed
decisions about how to execute a strategy,
including which brokers to use.
Investment managers are professionally
motivated to minimize trading costs in order to
maximize performance. Managers often apply the
same level of rigor to implementing a strategy as
they do to security research and portfolio
construction. Moreover, given the increasing
media and regulatory scrutiny of these issues, the
responsibilities of investment managers are only
getting more difficult. Now, more than ever, their
singular focus must be on serving the customer in
the most efficient, transparent, and unconflicted
manner possible.
In our over 30 years serving the investment
management community, we have worked in partnership with our clients to find solutions that have
been beneficial to both managers and sponsors. These solutions not only deliver the greatest value back
to the investor, but do so in manner that provides the greatest amount of disclosure of transaction costs.
This transparency allows the plan sponsor to assure their stakeholders that their money is being used
efficiently, and that they are doing everything possible to avoid the loss of value due to unnecessary costs.
Throughout these decades of partnership with our customers, we have learned one golden rule of
investing: you can always return greater value to the investor by lowering transaction costs. It’s not the
most exciting or glamorous topic, but it is the most reliable way we can help improve returns. At Instinet,
we’ve built our business by relentlessly chipping away at transaction costs in the most open and
transparent fashion possible.
TRANSACTION COSTS, VISIBLE AND INVISIBLE
Transaction costs are incurred every time securities are bought or sold. These costs are both explicit —
for example, any commissions paid — and implicit. Implicit costs, usually the larger of the two,
include, for example, the adverse effect that the trade itself may have on the price of a security, known
as market impact, or the opportunity cost of failing to execute a trade.
Transaction cost measurements capture both visible and invisible costs — that is, total trading costs.
The best way to think about total transaction costs is as the difference between a paper portfolio and a
real one. A paper portfolio is an imaginary portfolio in which the securities an investor wants to hold
are all acquired instantly, without cost, at a given benchmark price, say the previous day’s close. The
value of this portfolio can be compared to the value of the real portfolio, once constructed, in which all
transaction costs have been reflected.
Investment managers must focus
on serving the customer in the
most efficient, transparent, and
unconflicted manner possible.
4. 2
The difference between the two is commonly known as "implementation shortfall." Implementation
shortfall represents the total shortfall in the value of a security (or portfolio) that results from
implementing the trade—or failing to do so. This approach to measuring total transaction costs was
first described in 1988, and has since become the methodology of choice.1
(See Appendix: Inside
Implementation Shortfall)
HOW IMPORTANT ARE TRADING COSTS?
Transaction costs can have a significant effect on returns. Implementation shortfall in U.S. equity
markets has been estimated to range from 20 basis points to as much as 2% of the principal value of
transactions and orders.2
The wide range is partly due to differing assumptions about opportunity
costs.3
Taking the mid-point of the range, however, even an average 1% per year in lost performance,
before inflation and taxes, compounded over the average life of a pension liability, represents
substantial foregone value. If we apply it to the $12 trillion U.S. equity market, we get approximately
$120 billion lost to transaction costs every year.4
An example of implementation shortfall cited by one study was the performance of a portfolio of stocks
recommended by Value Line, an independent research firm. From 1979 to 1991, the Value Line portfolio
had an annualized paper return of 26.2%. The actual performance of the Value Line fund that invested
in these stocks was 16.1%. The difference — more than 10 percentage points per year — represents
implementation shortfall.5
The chart from Plexus Group demonstrates implementation shortfall by comparing the "potential
return" (paper value) to the "realized return" (actual value).
(Manager conducts
research and
develops a sound
investment strategy
within an optimal
environment.)
0
5%
10%
15%
20%
25%
30%
-10 -5 -2 Security
Purchase
Date
1 2 3 5 10 15 20 30
Return
Days Prior
to Security Purchase Date
Days After
Security Purchase Date
Implementation Shortfall
(Total Transaction Costs)
Potential Return
Realized Return
Research Period
Potential Return
Realized Return
LOST POTENTIAL
IMPLEMENTATION SHORTFALL MEASURED OVER THIRTY DAYS.
Source: Plexus Group.
5. 3
The vertical axis shows the rate of return on the investment decision. The horizontal axis shows the
days prior to and after the security purchase date. The chart shows that even though a manager may
have made a well-calculated, solid investment decision under optimal market conditions with
information as much as 10 days prior to the date of the purchase of a security (-10), value can still be
lost due to implementation shortfall. The shaded portion of the chart, the section between the potential
return and the actual return, is the amount lost in the time from trade decision to trade completion as
a result of transaction costs.
TRANSACTION COSTS AND EXECUTION — GOOD, BETTER, BEST
The legal definition of best execution is "the most favorable terms reasonably available under the
circumstances for a customer’s order."6
The definition is necessarily broad because it must apply to all
investors and any market conditions. As a result, it is difficult to apply as a quantitative test. This does
not mean, however, that best execution
cannot be measured. It can, but the
measurement must take subjective issues into
consideration also:
• The "most favorable terms" (e.g., price,
speed, or certainty of execution) depend on
the investor’s goal. If an investor pays an
inferior price to execute quickly against a
short-run profit opportunity—say, a takeover
bid—is this a failure of best execution?
• Opportunity costs count. If a broker
executes a trade at the best price available,
and charges a low commission, but only fills
half the order, has the duty of best execution
been met?
Implementation shortfall is one measure of
execution quality, though even it cannot
capture the context of the trading decision. It
does, however, measure total transaction
costs relative to the investor’s ideal outcome,
thereby accounting for both the investor’s goals and opportunity costs. Under this approach, best
execution is what removes the least in total transaction costs from the expected value of the investor’s
strategy. In other words, best execution is minimized implementation shortfall.
Of course, even with an effective measure, best execution is not an absolute standard. Execution
quality is relative, a matter of comparing costs between brokers and investment managers to assess
their average performance, while keeping in mind the specific investment strategies and risk tolerances
of the client, as well as the condition of the market at the time of execution. The goal is not to
eliminate all transaction costs—an impossible task—but to find and utilize brokers that can minimize
these costs as much as possible.
The goal is not to
eliminate all
transaction costs,
but to minimize
these costs as much
as possible.
6. 4
ACHIEVING HIGH-QUALITY EXECUTIONS
Implementation shortfall measures best execution after the portfolio has been fully constructed.
Investment managers, however, need a way to fulfill the legal duty of best execution throughout the
trading process. As a practical matter, how can this be accomplished?
The answer is to create the conditions under which it is most likely to occur. This shifts the emphasis
from the outcome to the process. The investment manager meets the duty of best execution by
following procedures calculated to achieve it — it is, in fact, the "trading process … that seeks to
maximize the value of a client’s portfolio."7
A best execution trading process should incorporate a number of factors. Among the most critical are
standards that help the investment manager choose brokers that will support the process. As a result,
many investment managers have begun utilizing best execution brokers. A best execution broker
should be able to:
• Protect client anonymity.
• Minimize total trading costs.
• Execute trades quickly.
• Help solve difficult trading problems.
• Provide efficient clearing and settlement.
• Search for and find liquidity to minimize market impact.8
How do best execution brokers accomplish this? Best execution brokers have generally designed their
business model to have those characteristics, in an effort to increase execution quality, without
ancillary business interests that could result in higher trading expenses.
For example, best execution brokers
using an agency-only model—brokers
whose firms do not trade on a
proprietary basis—eliminate the
potential for conflicts of interest.
(When utilizing brokers that have
proprietary trading desks, there is
always the risk of the broker trading
ahead of the client.) Anonymous
trading also eliminates the possibility
of information leakage, which can
also result in inferior prices. Typically
best execution brokers systematically
remove any other business interests
or practices that could negatively
affect execution quality.
The investment
manager meets the
duty of best execution
by following
procedures calculated
to achieve it — it is,
in fact, the "trading
process … that seeks
to maximize the value
of a client’s portfolio."
7. RESPONSIBLE MANAGEMENT OF COSTS
Instinet Group has over 30 years of experience in working with some of the best investment managers
in the financial services industry. With our expertise, we have identified three proven steps that asset
managers use to insure that clients meet the fulfillment of their fiduciary duties by controlling
transaction costs and reducing unnecessary plan costs.
IDENTIFY TRANSACTION COSTS FOR YOUR CLIENTS
Explain to your client where costs are incurred along the trading cycle. Regularly measure execution
quality, using a system that:
• Employs implementation shortfall methodology.
• Covers all orders placed, whether or not they are fully executed.
• Breaks costs down by broker and investment strategy — e.g., value, growth, etc.
• Separates transaction cost components — e.g., commissions, spreads, market impact, opportunity
costs.
• Reports back periodically to the plan sponsor.
Transaction cost disclosures should allow you and the client to compare brokers and investment
strategies that have been successful in the past.
UTILIZE A TRANSPARENT BROKER SELECTION PROCESS
Ensure that your clients understand how brokers are selected and how commissions are allocated.
Information provided could include:
• A general description of your firm’s commission voting procedures.
• A list of approved brokers and a rationale for each broker’s inclusion on the list.
• Procedures by which brokers are added to or removed from the list.
• Commissions allocated to each broker (in dollars and as a percentage of the total commission pool).
• The reasons for each allocation.
• Average commission rates paid to each broker.
• A description of the services purchased from each broker.
• The monetary value of these services.9
• Justification for any divergences from planned allocations (the difference between commissions
allocated and commissions actually paid).
SHOW HOW PLAN BROKERAGE DOLLARS ARE SUPPORTING CLIENT OBJECTIVES
In addition to showing how costs are minimized, it may be helpful to show clients how the brokerage
expenditures are directly benefiting their plan. Because costs can never be completely eliminated, plan
sponsors should see the connections between their investment strategy and their fund’s expenses.
Clients should understand, for example, that their index fund is not cross-subsidizing another client’s
growth fund. Concrete examples are often well-received.
In an environment of increased public scrutiny of investment management, there are a number of steps
advisors can take to ensure that the money they oversee incurs the minimum amount of transaction
costs. While these costs will never be completely eliminated, reducing them can lead to higher net
returns for the end investors—the individuals that the plan sponsor represents.
5
8. 66
APPENDIX: INSIDE IMPLEMENTATION SHORTFALL
Implementation shortfall can be thought of as the difference in value between a paper portfolio and an
actual portfolio. Assume an investment manager conceives an investment strategy that requires the
purchase of 1,000 shares of XYZ. On the day that the buy list is sent to the trading desk, a paper
portfolio is created valuing the 1,000 shares at an agreed-upon benchmark price —for example, the
previous day’s closing price. As each purchase is made, the portfolio is revalued at the actual
transaction price, taking account of fees and commissions. When the process is complete (or abandoned
before all 1,000 shares are acquired), the value of the actual portfolio is compared to the paper portfolio.
The difference is implementation shortfall.
Transaction costs fall into three major categories:
PAYMENTS TO BROKERS AND DEALERS
Trading intermediaries like brokers and dealers are paid through commissions and spreads.
Commissions are explicit fees paid to agency brokers, typically quoted in cents per share in the U.S.
Institutional commissions range widely from less than one cent per share to six cents per share,
depending on broker and trade; the average is about five cents per share.10
Instead of a commission, the
broker-dealer may be compensated by the spread. The dealer buys at one price (bid) and sells at a higher
price (offer), capturing the spread between the two. This is a cost to the dealer’s customers — the seller
gets a lower price, and the buyer pays more, than if the two met directly. In one 1993 study, U.S. equity
spread costs averaged seven cents per share; decimalization has subsequently sharply narrowed
observed spreads, though research on realized spreads is more ambiguous.11
MARKET IMPACT
Market impact measures the effect of the trade itself on a security’s price. By the law of demand and
supply, a large buy order will raise the price of a security, and a large sell order will depress it. Market
impact is frequently described as the price concession that needs to be made to get the trade done.12
If
the other side is a dealer or a broker proprietary desk, rather than an end-investor, market impact may
blend with spread costs. Traders manage market impact by breaking orders down and trading them over
several days — that is, by concealing information about the size of the order. The risk is that the market
price will move against the trader over that time, in which case a timing cost is incurred. This is really
an opportunity cost; the potential return lost to delays (or cancellations) in execution.
OPPORTUNITY COST
Opportunity cost results from delaying execution to lessen market impact, or not being able to make
the execution at all, or abandoning part of it because the market has turned against the strategy (either
because of broad market trends or because the market has recognized the value of the strategy). If an
investment manager’s strategy envisaged the purchase of 100,000 shares, and only 50,000 were
purchased, the lost potential returns on the remainder represent opportunity cost.
9. 7
NOTES
1. Andre F. Perold, "The Implementation Shortfall, Paper vs. Reality," Journal of Portfolio
Management (Spring 1988). The concept was used earlier by Jack Treynor, but Perold’s paper
popularized it. (Jack L. Treynor, "What Does it Take to Win the Trading Game," Financial
Analysts Journal [Jan-Feb 1981]).
2. Securities and Exchange Commission, Request for Comments on Measures to Improve
Disclosure of Mutual Fund Transaction Costs; Proposed Rule (December 24, 2003). Also,
Wayne Wagner, "Cost versus Liquidity: The Quest for Best Execution," AIMR Publications
(2003).
3. Costs also vary according to factors like market capitalization, trade size and market
conditions — for example, small trades in large-cap stocks in neutral markets should incur
smaller costs than large trades in small-cap stocks in adverse market conditions.
4. John C. Bogle, "Whether Markets are More Efficient or Less Efficient, Costs Matter," CFA
Magazine (Nov-Dec 2003). Bogle figures the total cost of financial intermediation in the U.S.
equity market — money management fees, transaction costs, custody charges, etc. — to be
some $300 billion annually or "nearly 3% of the value of that $12 trillion market." If our
estimate is correct, transaction costs would account for about a third of total intermediation
costs.
5. David J. Leinweber, First Quadrant — Investment Management Reflections (1994). Leinweber
notes that some of the shortfall is attributable to the brief delay Value Line imposes on its
fund to avoid trading ahead of its subscribers, i.e. opportunity costs.
6. Disclosure of Order Execution and Routing Practices, Securities and Exchange Commission
Final Rule No. 34-43590 (17 November 2000), at http://www.sec.gov/rules/final/34-43590.htm.
7. Association for Investment Management and Research, AIMR Trade Management Guidelines
(2002), available at http://www.aimr.org/standards/ethics/tmg/index.html. Note that seeking
to "maximize a client’s portfolio" is consistent with an implementation shortfall view of best
execution.
8. AIMR Trade Management Guidelines, supra. These characteristics of a best execution broker
are based closely on the Guidelines.
9. Third-party services like research from independent providers can be valued by soft-dollar
invoices submitted by those providers for the broker to pay. The value of the broker’s
proprietary services, like in-house research, would need to be carefully estimated.
10. Securities and Exchange Commission, supra.
11. Wayne H. Wagner and Mark Edwards, "Best Execution," Financial Analysts Journal (Jan-Feb
1993).
12. Stephen Berkowitz and Dennis Logue, "Transaction Costs: Much Ado About Everything,"
Journal of Portfolio Management (Winter 2001).
11. Instinet Group Incorporated • 3 Times Square • New York, NY 10036 • www.instinetgroup.com
For more information please contact your
Instinet Group representative or visit us
online at www.instinetgroup.com.
