What about the roleof the specialists? I know how the other three guys feel. How do you comedown on this issue?NATAN TIEFENBRUN: We looked at the AIMR guidelines atInstinct, and felt quite comfortable with them. We have a broad mix ofclients at our firm – institutional, hedge fund, broker dealer, direct access,and retail. They all have different needs. We track their needs on fivedifferent dimensions. The first is obviously price (and there is a great dealof emphasis on it). The second one is, as Minder mentioned, time (the needfor speed). The third is liquidity (the need for size). The fourth is efficiencyin the sense of information leakage. If you are going to take a long time totrade, you want a means of trading where you are guaranteed to leak as littleinformation as possible. The fifth is operational efficiency. This oneappeals to the big institutional clients. Every investor has a different mix ofthese five dimensions.To answer your question, I do not think that it is possible to measure bestexecution. I do think it is possible to measure transaction costs andimplementation shortfall, and that there is no excuse for not doing so.There is a lot of fluff around. People try to avoid measuring transactioncosts and implementation shortfall by using benchmarks that areinappropriate. Most of the smarter institutions (certainly the quantitativelybiased ones) are doing it the right way. But it is important to distinguish
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between measuring execution costs and implementation shortfall, andmeasuring best execution. Best execution is not a number, it is a process.How do you go about achieving best execution? You look at themotivation for the trade, you evaluate your needs in the five dimensions thatI spoke about, and you choose the appropriate trading strategy and tradingavenue. It is through the process of the trade, how you monitor what isgoing on, your response to the feedback that you are getting (if indeed youhave chosen a means of trading that gives you feedback), and your ability torespond. After the trade, it also matters how you measure the actual cost,both in absolute terms and also relative to the costs that you anticipatedbeforehand. There is more. Subsequently, you must evaluate your ownstrategy selection and your own internal processes. Also, you must evaluatethe performance of the different fiduciaries who have been involved in thetrade with you.We have defined best execution as a very holistic term. This is all part ofthe best execution obligation. I think that is right. It should be a holisticterm. This is what we should be very focused on – how to get a moneymanager to look at the entire process, from end to end. How do weminimize all of the frictions that exist between the portfolio manager and thetrading desk, and between the trading desk and a broker? How do wemitigate the conflicts of interest that exist?The U.K. government felt that money managers spend their plansponsors’ assets too freely. That, in fact, was the underlying motivationbehind the Myners report. Money managers were just spending their plansponsor’s assets for soft commissions, research, etc. Traditional brokerdealers might be incented to turn a quick buck, rather than to deliver the besteconomic price to their clients.So best execution to me is about the holistic process, and about how weget firms to adopt it. This involves educating the end clients (the plansponsors). Unfortunately, we have end clients who are poorly educated. Inmany markets, less so in the U.S., they are volunteers.78 They are not doingthis professionally. Further, there is a real kind of ‘cover your ass’mentality, where they give all of the responsibility over to a consultant. Ifthe consultants were better educated, that would not be such a bad idea(laughter). But most of them are not.MADHAVAN: So, if I could paraphrase, transaction costs can bemeasured with a high degree of precision. Transaction costs are an elementof best execution, but obviously there is a whole process. And it is thatprocess that we need to focus on.78
Most officials on pension boards in Europe, for example, are essentially unpaid volunteers.These posts are not fulltime salaried jobs.
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You didn’t quite say this, but let me take a leap. Given your commentsabout the educational level of the parties involved – plan sponsors,consultants, and so on – can I presume that it is an argument for regulation?Can I say that you are in favor of government regulation and the AIMR tradeguidelines? Do you believe that things like this move the industry forward?Or perhaps you think that they will naturally occur.TIEFENBRUN: They are occurring naturally because people aregetting a better understanding of what their fiduciary obligations entail. It isnot so much regulation, as it is court cases that are advancing it. Forexample, in the U.K., Mercury Asset Management was sued for not havingthe appropriate controls. As a consequence, it will be many years before wesee an event like that again in the U.K. market.Through experience, things are always evolving. The danger ofregulation is that the regulators come in with a one-dimensional approach.They say that you must minimize cost, or that we must have a marketstructure that will protect the retail investor (as has happened here in theU.S.). In my mind, the regulators have often missed the boat. I amencouraged by the remark that the SEC is looking at the world in a similarway to the AIMR. But I also think back to the order handling rules. Theserules were a good thing for the retail investor. But I do not think that theSEC put serious thought into how the rules would affect the institutionalcommunity. So I am a free-market kind of guy (laughter).MADHAVAN: Now to Wayne. This is a natural set up for him. Yourfellow panelists, Wayne, seem to believe that there are no issues inmeasuring transaction costs that it is pretty straightforward to do. Butanybody who has actually gone out there and talked about transaction costsmay have a different impression. You sometimes get blank looks andcomments like, well, we trade with market on close orders, and they do it forzero commission, so we have zero trading costs.Trading costs are an element of the best execution process. Is it so easyto measure them? What benchmarks do you use? People use differentbenchmarks. VWAP, opening prices, closing prices, mid-points, all kinds ofthings and, as they do, they come up with very different numbers. I am surethat with the Plexus data, you have run the numbers a bunch of differentways and have gotten very different answers based upon the benchmark thatyou pick. If we cannot pick benchmarks for measuring trading costs, howcan we regulate a process like best execution in any sort of a meaningfulway? Start there (laughter).WAYNE WAGNER: The place where I would like to start is a bitdifferent. There was a lot of confusion on the AIMR committee aboutwhose behavior we were actually prescribing standards for. My view was
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that the regulations that we have governing the 33 Act79 companies (theexchanges and the broker dealers) pretty much define what best execution isfor that part of the universe. But we did not have a decent standard for amoney manager, or for a trader for a money manager. What standards applyto the behavior of these people? How can they tell whether they are doingtheir part toward best execution or not? We ended up with the followingrather soft sounding statement. We said that, in effect, the objective oftrading is to capture the value of the process that is underlying thosedecisions.But it gets complicated. These decision processes are all very different.Consequently, what represents best execution for a hedge fund that wantsimmediate execution, may not apply to Minder who is mostly running indexfunds and therefore is interested in achieving lowest possible costs. It is alsodifferent for a momentum manager who simply has to get the shares that hisportfolio manager has decided on into the portfolio, no matter what the cost.You cannot make a decision about what is best execution, until you haveconsidered what the decision process is that is driving that execution. Youreally have to assess trading costs in the context of the values of the portfoliodecisions that are being made. Then you can make rather simplemathematical (actually arithmetic) computations to determine whether yourtrading process is adding value to your client portfolios, or is taking valueaway from your client portfolios.That brings up a couple of other issues. Here is the first. You canaccurately describe whether the flip of a coin was a head or a tail byobserving the coin after the fact. But that observation does not describe theprocess of coin flipping. The process of flipping a fair coin is described bythe probabilities, 50% heads, 50% tails. You cannot tell from one trade,overlaid with the kind of noise that Bob was talking about (both noise in thefundamental process and noise induced by the trading process), whether itwas heads or tails, a good execution or a bad execution.The second thing is, you need a benchmark that makes sense. Let themeasurement be an ‘x minus y’ kind of statement. That is, if you have x79
The Securities Act of 1933 mandated disclosure of information about new corporatesecurities, required that all new corporate securities be registered with the Federal TradeCommission (later the SEC), demanded that financial information in a registrationstatement be certified by an independent accountant, and stipulated antifraud provisions.The Securities Act of 1934 established the SEC and empowered the SEC to approvecommission rate changes proposed by the exchanges and to request commission ratechanges, empowered the SEC to prohibit stock manipulation, established regulation of thebusiness conduct of broker/dealer members of an exchange, left disciplinary power overits members to the exchanges, and empowered the Federal Reserve Board to set minimummargin requirements.
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dollars when you start the trade and you have y dollars of value after you arethrough with the trade, then, in some sense, x minus y is what it must havecost you to get that decision into the portfolio. But that is not enough. ‘xminus y’ does not say whether or not it was a good trade.What you need is a difficulty-adjusted measurement. For instance, if youdo a trade equal to two days volume under momentum conditions that arestrongly adverse to the trading situation in a small cap stock, you must havea high benchmark. That is, high relative to what you would apply to a 1000share order that got sliced and diced and dumped into the NYSE’s DOTsystem. We have been working hard on the equations that would help ushere. And we have our(unlike the Madhavanwhich are around . 05or . 06).MADHAVAN: This is Plexus data I might add (laughter).WAGNER: Yeah, well, it took U.S. a long time to get past that. Butwe have them up to around 15.MADHAVAN: Meaning that you are leaving 85% of the variationunexplained (laughter)?WAGNER: Yes, but we have big samples (laughter).In some of the overseas markets, we havegoing up to around . 3,which is about as good as betas. But we do have a lot of independentsamples. On Minder’s desk, tens of thousands of trades are handled everyquarter. This is a good sample size. You can see what the process isgenerating in terms of whether or not it is bringing the value of the ideas tothe portfolios.MADHAVAN: Minder, ultimately, these are statistical constructs. Doyou ever think about execution on a trade-by-trade basis, or is it purelystatistical aggregates?CHENG: The building block is trade-by-trade, but we do not decidetrade-by-trade whether a broker is doing a good job or a bad job. There willalways be something better than the average, and something worse than theaverage. Consequently, we take the statistical view as opposed to the tradeby-trade view.I would like to add that, although best execution cannot be fullymeasured, from an asset managers point of view (whether an active, index,or momentum manager, we tend to do them all), it is important to recognizethat, ultimately, performance is what counts. And performance can only becaptured by price. I believe that trading costs are the biggest component inbest execution. But you should also consider some other things, likeoperating efficiency. When choosing between two brokers with similartransaction costs, this can be used as a tiebreaker.That is, if you have two or three brokers who, from experience, give youalmost identical trading quality in terms of the score, then the one that has
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higher operating efficiency (or perhaps the one that offers you a betterdinner) would... (laughter)... I am speaking for others here (laughter). Butthe best way to do things is to quantify as much as possible. Othermeasurements such as operating efficiency can be used as a tiebreaker.Another point that needs to be clarified is that best execution is differentbetween the buy-side and the sell-side. That point has not yet been made.Best execution largely refers to a similar set of principles between the buyside and the sell-side. However, there are non-trivial differences betweenthe two sides that would make the definition of best execution differsomewhat between them. First of all, the buy-side is mandated to have itsfiduciary responsibility for its ultimate clients whereas the sell-side is not.In addition, the buy-side, typically not being a member of a stock exchange,does not access the conventional exchange-centered liquidity directly –although ECNs have changed some of that – whereas the sell-side does.What this means is that what defines best execution for the sell-sideincludes, among other factors, the choice of exchanges whereas the buy-sideis generally not accountable for it. The analogy for the buy-side would bethe choice of brokers, which obviously will not be an issue for the sell-side.MADHAVAN: It is a very good point.I should also clarify that the whole day we have been talking about equitymarkets, except for the session on options. A lot of what we are saying herecarries over to other markets and to other asset classes. It carries over withone proviso, however – it is much more difficult to measure the kinds ofthings we are trying to measure. The data just are not there.WAGNER: Yeah, you really need some kind of price tape before youcan...MADHAVAN: Natan, is there something that you want to add?TIEFENBRUN: Minder, you emphasized a purely statistical processthat is not able to use individual trades. We find that clients are in somesense using individual trades. We typically trade portfolios. We would notwant anybody to judge us on the basis of a single portfolio of equities but,for any given portfolio trade, you can look at the distribution of the costs forthe individual shares and the individual names associated with the trades. Awide distribution around the mean might indicate a lack of discipline, or thatsome mistakes are being made. Similarly, while the implementationshortfall80 that was my true cost is not always a good measure in individualtrades, it is possible to go to a VWAP-type benchmark. A VWAPbenchmark definitely is not a measure of cost. But it can be a useful80
Implementation shortfall is the standard measure of realized and unrealized transactioncosts.
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measure of broker diligence and broker discipline in participating in themarket.So it is possible to measure some aspects of fiduciary performance withindividual trades, but not to measure ultimate cost. Again, best execution isa combination of all of those things. If you give a broker an order and say,‘participate in the hour,’ and if their execution price differs wildly from theaverage for that hour, then you can say, ‘hang on a minute, there is a lack ofdiscipline, a lack of fiduciary diligence there.’ Perhaps individual tradescannot be used to measure transaction costs, but they may be used tomeasure some aspects of execution quality.WAGNER: We break reports down by individual broker. If a brokerdoes not look good, the client beats him over the head and things change.There are variables inside a brokerage firm that are under the control of abroker. If you demonstrate that this issue is important to you, you will get aresponse. I suppose that if you were to demonstrate a love for hockey, youwould get a different response (laughter).MADAHVAN: Which brings to mind another question for Ted.Minder makes a very good distinction between the exchanges and the buyside and the sell-side. Should we also make a corresponding distinctionbetween retail and institutional when we talk about best execution? Is theindustry too focused on retail concepts?ARONSON: That is a good question. I will make a prediction thatwill get to the answer. For the first time, our industry is really focused onthe aggregate issues of trading and implementation costs. I think it iscoming to a head. By the way, I have been making this same prediction forthe last 27 years, ever since May Day. 81 But I do think that the forces youmentioned at the outset are coming together – the Myners report from theU.K., the SEC’s focus on the costs of doing business in this regard and, onehopes, the AIMR standards (which I agree with Wayne turned out to be a bitof a camel, when we set out to design a horse (laughter).There is something that we have avoided here. It is a dirty secret, ormaybe not such a secret thanks to the likes of Jack Bogle.82 There is thefailure of money management. There is the failure in my business, in myindustry, to add value. We have been through a lot in the markets. I will notbelabor the point of the bubble and its subsequent deflation. But investors,both retail and institutional, are sitting up and saying that we are mad as helland are not going to take it anymore. Think of how retail investors are81
On May Day (May 1, 1975), fixed stock brokerage commissions were finally abolishedwith the enactment of the 1975 amendments to the Securities Exchange Act of 1934.
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John (Jack) C. Bogle is founder and former Chairman of the Vanguard Group.
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switching in droves from mutual funds into money market funds. As anindustry we’ve failed and we haven’t added value. Transaction costs are partof this issue.MADHAVAN: We have time for questions from the audience.MARC GRESACK83 [From the Floor]: I have been in the institutionalbrokerage community for about twenty years. I talk to a lot of plansponsors. I agree wholeheartedly with Ted (and with all the others to adegree, as they represent their cases). 1 see that the plan sponsors are veryconcerned about performance measurement. The low returns that we havebeen experiencing of late definitely have something to do with it.In an industry where every manager is being measured by his ability toperform across a number of segments (and it is all extremely quantifiable),the plan sponsors are upset at trading. They wonder why tradingperformance cannot be measured like everything else in this industry. Thatfeeling is really driving the present condition. All the managers go throughit.Minder, when you talk to a plan sponsor about your trading desk’sperformance on behalf of the sponsor, doesn’t tracking error on theperformance side have something to do with your story? An index managerjust wants to trade at the close to get the tracking performance, because thatis a good measure of index fund performance. It does not matter what theprice is, just as long as he gets the close. However, is it a good performancemeasure? Maybe yes, maybe no, but it is the accepted benchmark.The same thing needs to happen in trading. I am not advocating onesingle benchmark, but the need for a widely accepted benchmark explainswhy VWAP is popular in the plan sponsor community. At least it gives onenumber that, although arguably imperfect, they can point to. They can lookat all their other managers on the basis of one single benchmark. When amanager who is more in line with what Ted does visits with the plan sponsoron a quarterly basis, he can explain to the plan sponsor why he may haveout-performed the VWAP.You take advantage of liquidity so that you may do better on a VWAPmeasurement. American Century, on the other hand, with their momentumfunds, looks terrible. American Century may try to explain away why theydid well or didn’t do well, but the fact is, there is a great need for a singlebenchmark.I have met with a lot of buy-side traders who talk about the importanceof having a feel of the market, the sense of a buying or a selling opportunity.But if they talk to a plan sponsor about things like intuition, guts, and market83
Marc Gresack is Chief Executive Officer of Pipeline Trading Systems. At the time of theconference, he was a strategic consultant for Brut.
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feel, the plan sponsor thinks that this trader is taking way too much risk.Face it; we are in a very risk averse environment. That is what is driving theAIMR to set standards. So, yes, the process is complicated, but so too is theinvestment process.WAGNER: I can think of one example that supports what you havesaid. I have these numbers, and you have to interpret them for what theymean. I am not picking on you, Ananth, but if you look at the executionsthat you get through POSIT, they are beautiful. But you also have toconsider the fact that we submitted these orders and some got filled, andsome did not get filled. Was there a difference between those that got filled,and those that didn’t? Is there a subtle adverse selection process at work?You cannot complete a cross without the other side. What brings the otherside to the table is that they have information. Thus, you will get large fillson POSIT only when the other side has the information edge (or at least thebigger orders, which means their orders will overhang and drive the pricedown if a sell or up if a buy).Oversimplification is not what we are looking for here. We are lookingfor something that captures as much of the essence of the process as we can.TIEFENBRUN: I would like to add something to Wayne’s point.There is a link between transaction costs and market structure, or thebusiness model operated by a firm.84 You know, ITG’s POSIT match looksterrific in the Plexus studies. I got Plexus numbers yesterday when Ireturned from a trip, and Instinet comes out on top in 11 out of 12 categoriesin listed and 12 out of 12 categories in OTC. That is lovely, but we ask why.I would love for the audience to see where they would stick their votes here.You can pick three factors, but number one is that all of Instinet’s traders aregeniuses (laughter). Although that typically scores kind of low with mostpeople (laughter).The second factor is that you tell a CIO his performance is high becausehis traders are geniuses. That doesn’t tend to score too high either(laughter).The only remaining explanation, I guess, is that it is just something aboutour business model. Unlike the principal trading model, we don’t takepositions, we don’t make markets, we don’t trade for our own book, we84
Tiefenbrun used a simple analogy to illustrate his point in a follow-up interview. If acustomer employs a person to purchase a specific product for him as his agent, an agentwho knows he gets to keep the change from the money the customer gives him for thetransaction, this agent will presumably shop around for the lowest cost product available.‘In an agency transaction you are not buying to make money for yourself. You are beingjudged solely on the quality of the execution you give your customer,’ Tiefenbrun said.So there is a direct link between the agency business model and the quality of theexecution, he notes.
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protect your anonymity, and we give you control. Ultimately, if you look atall of the Plexus studies, the agency broker dealers or ATSs that have thismodel continuously outperform, even on a difficulty adjusted basis.Something that surprises me is that the buy-side is not more demandingfrom the traditional brokers. The Plexus numbers are difficulty adjusted. Itis not just the case that ECNs are doing well because they get easy trades, orthat ITG does well only because it gets easy trades. ITG does well becausethat is all they get paid to do. Because that is the business they are in.There are many players in the market who are in the business of tradingand profiting from their own trades. They are in the primary business ofleveraging the information they get from their clients. When a broker dealerleverages the information that you give him, it is always to the detriment ofthe buy-side.MADHAVAN: I totally agree with that comment (laughter).TIEFENBRUN: I thought you might (laughter).MADHAVAN: One of the advantages of turning a spotlight on all ofthis is that we are going to get better practices.I have another question that I want to throw out to the panel. Five yearsfrom now, when the AIMR guidelines are widely accepted and are notcontroversial anymore, when the SEC has weighed in by going along withthe AIMR, when Myners has transformed the U.K. industry, and whenequations such as Minder has shown us do not look so startling– five yearsfrom now, do you think that all of this will alter practices such aspreferencing and soft-dollaring? Will it change those things, too?ARONSON: It will change things significantly. For the first time in 27years, there will be a significant, and I mean significant, decrease in the useof soft dollars, in the related sins of directed trading, and all that sort of stuff.That will be the most important result of the AIMR task force guidelines.CHENG: I agree completely. The equation and the methodology that Iput up can only work because BGI does not do soft dollars. If you do softdollars, a large portion is not trading related. Softing makes it harder tomake the performance measurements accurate. So soft dollars are atroublemaker in this case. I know it is a common practice in the U.K., aswell as for a lot of asset managers here. Directed brokerage is also the samething.MADHAVAN: Preferencing, payment for order flow? Same thing?CHENG: Yes, same thing.TIEFENBRUN: I am going to disagree. I think that soft dollars can bethe lesser of two evils in some respects. The real sin is that paying fullservice commission fees, bundled commissions, to get research and IPOaccess, results in your not knowing just what you are getting for your full
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service commission. With soft dollars, the agency broker comes along andsays, ‘I will bundle these services, but at least I will price them explicitly.’The money management community has neglected to tell the plansponsors how much softing they are doing. That is a mistake. The plansponsor sees soft dollars, and knows it is going on, and is identifying it asthe problem when they do not really understand the concept of bundled fullservice commission rates.85 I think the regulators and the plans are focusingtheir efforts on soft dollars when they should be focused on forcing a generalunbundling of brokerage commissions. As to the other stuff, I agree thatdirected trading and payment for order flow will go away.86ROBERT SCHWARTZ87 [From the Floor]: I would like to ask AnthonyNeuberger a related question regarding the Myners report. I know from yourreport and the like, that it is not easy to respond with a positive solution tothe problem that the Myners report has unearthed. But Anthony, one of thethings that your report considered is transparency. We are now talking aboutbeing more transparent about what the costs are. How far do you think thattransparency about execution costs will go towards solving the conundrumof the Myners report?ANTHONY NEUBERGER88 [From the Floor]: There are two aspects totransparency. One is transparency of transaction costs, which would bebeneficial, although it is difficult to interpret the figures exactly. The othernumber that would be really interesting is much greater transparency overthe commission costs. Everybody had been forecasting since May Day thatyou would get unbundling of transaction costs from the other servicesprovided by brokers. I still do not really understand why this has nothappened. But if the debate about transactions costs and Myners leads to a85
In soft-dollar arrangements the costs are calculated on an implicit basis with full servicebrokers and on an explicit basis with agency brokers. In other words, on the former, thetotal costs for the execution and other services provided to a client are not broken out. Onthe latter, there is an ‘explicit’ soft dollar cost: the cost of the execution and the costs ofthe other services provided as a proportion of each agency transaction.
86
The introduction of decimal pricing in the U.S. equity trading markets caused many dealersto reexamine their payment for order flow arrangements. Some have ended the practicebecause of sharply reduced spreads. Decimal pricing, on the other hand, would tend toencourage directed brokerage and soft-dollar arrangements on the Nasdaq markets sincelarge-scale agency style transactions are now popular.
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Robert Schwartz is Speiser Professor of Finance at the Zicklin School of Business, BaruchCollege, CUNY.
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Anthony Neuberger is Associate Dean of the Full-time Masters in Finance Programme atLondon Business School.
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clearer demarcation of what you are getting for your commission charges,the ultimate end users will be better off.There is a great deal of dishonesty that comes about by softing, by thefact that you are getting these bundled services. Research and informationare all bundled up with transaction costs. Greater transparency here wouldbe enormously helpful.TIEFENBRUN: I do not think it matters what industry you are in. Thereason people bundle is to protect their margins. Broker dealers bundle theirservices to make you pay a higher price. Instinet would love to bundle aswell. It is just that we have been so transparent in the past that nobody willlet us do it. But broker dealers bundle to protect their margins and to forceyou to pay a higher price. They force you to consume a wider array ofservices, whether you want to or not.MADHAVAN: Let us take one final question.GEORGE BODINE89 [From the Floor]: I have two questions. The firstfor Ted Aronson, and the second for Minder.Ted, you say that you assess all your brokers at the end of each year. Doyour traders give 100% discretion to the brokers? Most of the traders I knowon the buy-side give maybe 10% or 15% discretion to the broker, and 80%to themselves. So, when you knock a broker off the list, are you really beingfair to the broker versus your own trader?ARONSON: Great question, and it is easy to answer. We give 100%discretion to our traders–one of whom is in this room today – to choose ourbrokers, and our traders in turn give 100% discretion to the brokers chosenThe brokers are assessed by implementation shortfall standards. We go outof our way to make sure to balance the array of trades that go to each broker,given the difficulty of the trades as measured by Plexus, ourselves, and someothers. After measuring the difficulty, we actually use other dimensions toparse the trades.When we finally let this guillotine down, we know that it is a fairassessment of each broker. If we were to gum up the works along the way,take away discretion from the traders in my shop, throw in encumbrances ofany kind you want – then, the whole process falls apart. So it is pure and itis pristine. I am no choirboy (laughter), but at least at the end of the day, weknow this assessment is for real.BODINE [From the Floor]: This is my question for Minder. I strugglewith it myself. A big component of your formula is the assumption that you
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George Bodine is Director of Trading at General Motors Investment ManagementCorporation.
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make about execution costs. How confident are you, Minder, in yournumber?CHENG: The way we do this is fairly integrated. The expectedtransaction cost is an all in cost, including commissions and opportunitycosts, and so on and so forth. It is the whole ice