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Research: How Are PAEG/Ls Formed

Research: How Are PAEG/Ls Formed

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Published by: Wayne H Wagner on May 05, 2009
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9rorrlt
uildingBetlerPerf ormernceCOMMENTARY
77
JULY
2OO3
RESEA
RCH:
HOW
ARE
PAEG/L@S
FORMED?
Market
disciplineand
regulatorypressureare
forcingtraders to
evaluate
the
qualityof
theirtrading.Thiscan
be
done
bypeer
groupcomparisons
or
against a cost
benchmark,preferablyboth.As
the
benchmark
becomes
morerelevant to
trade
evaluations,traderswant
to
know
what's
behind
the
PAEG/L
conceptapplied by
Plexus
since
1994.ThisCommentary discuss
the
benchmarking
process
indetail.
Why
Did
Plexus
Create
The
PAEG/L
Concept?
PAEG/L
-
Plexus
Average
Execution Gain/Loss
-
is
a
benchmark
for
evaluating
the
quality
of
execution
of a
trade.
The
Alpha
Capture@
implementation
shortfall approachanswers
the
ouestion:What
didit
cost
to
execute
this
trade?
The
PAEG/I-
puts
this cost
measuring
in
contextby answering thequestion"Whatshould
it
cost
to
executethis trade?"
"Whatshould
it
cost?"refers
to
the
typicalexperience
of
professionalinvestmentmanagers,
traders,
and
brokers executing simtlar
trades
in
si
milarcircumstances.
The
PA.trGi!
r'neasrrre
ofeynactedcoqt
i-e
d45ir.rarl
from
a
statisticalregressionapplied
to
recent
tradedata.
Plexus' unique database contains
a
very
large sample
of
manager-to-trader-to-brokerlinked trade data andprovidesthe abilitytocreateintelligent
estimatesof
costs through time.
Why
fs
lhr's Important?
A
good
benchmark
signalswhether
actual
transaction
costs
reflect
good
or
poor
performance
by
managers, traders,
and
brokers.
The
benefits
of better
benchmarksinclude:
1.
Trading
and
brokerage
skills
are
more
accu
rately
attributed
;
2.
Managers and
traders
develop
a
bettersenseof
when
and
why trading costs
rise;
and
3.
Valuable insights
lead
to
actionitems
that
directly
enhance
future
pedormance.
Without
a
good
benchmark,organizations
often
cannotmake
the
critical
first
leap
from
measurement
to
evaluation
that
leads
toimprovement.
Sfafisfrcally
Speaking,
What
Is
the
Goal
ofPAEG/L
Research?
Theobjectiveof PAEG/Lresearch
is
to explainthe
variation
in
trade
cost.
This
requires:
1.
A
rich
database
of
observations,consistingofthe
experienced
costs
(thedependentvariable)and a
variety
of
potentialcausativefactors;
2.
A
high-powerregressionpackage,capableof
running
very large
problems;
3.
A
test-bedfacility
to
determine
not
only
how
well
we
can
explain
the
variation
within
the
sample
(explanatory
power)
and
more
importantly, theabilityto explaincosts
in
out-of-sample,
i
ntothe-futu
re
appl
ications
(forecasti
n
g
power);4.
A
deep
understanding
of
the
economics
oftrading
and the
vagaries
of
trading
data.
 
How
Do
You
Select
Explanatory
Factors?
An
appropriatebenchmark
should
take
into
account
trade- and
stock-specific
factors.
For
example,
it
should reflect
the fact that
more
difficult tradessuch
as
large
trades
usuallycost
more
than
small
trades.
A
regression-based
approach,
such
as
PAEG/L,
permits
us
to
try
variouscombinations
of
variables
to
see
what
works bestas
a
forecaster.
Every
trade
is
different
and
tradersassess
many
factors
as
they work
trades.
Defining
an
exhaustive listofvariablesand conditions
thatcapture
ihe
fuii essence
of
trading
is impossible.
The
trick
is
to
identify
a
set
of
factors
that
account
foras
much
of
the
variability
in
trade
cost as
possible.
Finding
thesefactors
is a trial-
and-errorprocess.
The
modelingprocess
is
quite
similar
in
scopeandinaccuracy to what
a
researchdirector
would
go
through
while
developing a stock
valuation
model.
Over
the
past
fifteen
years,we have
identified
and tested
dozens
of
factors
in
combination,
including variousmeasures
of
liquidity,
volatility,
trend,
market,
size,and
nature
of
the
trading
desk
(size,
style,
etc.)
We
often
find,
sometimes
much
to
our
surprise,
that
important-sounding
factors
do
notadd
forecasting
power.
This
happens
when
one
of
the
existing factors
is
a
strong surrogate
for
anotherand, so to
speak,
steals
its
thunder.
Forexample, tagging tradesaccording
to
manager
style
(e.9.growth,value)
doesn't help
because
the
trade size,
company
capitalization
and
short-term
price
momentum
already capture
the
differences
betweenmanager
styles.
How
Are
The
Equations Produced?
PAEG/Ls
are
derived
quarterly
through
a
multi.
step
process:
1.
Measure
total
transaction
cost
from
time-
stamped
managerorder
through
completion;
2.
Form
a
rolling
six
monthclient
data
universefor trades
world-wide.
Equations are updated
quarterly
to
reflect evolving market
structureandconditions;
3.
Art as
well
as
science
is
reouired.
The
regressionequations
are
carefully
screened
for
outlier observation effects
that
can
easily
distort
the
equations.
An
example:
a
very
largetrade
that
fortuitously
found
the
otherside
for
a cross
al
near-zero
cost.
lt
would
be
unfair
to
expect
a
trader
to
duplicate
those
circumstances,
so
these
irreproducible
observations are
d
iscarded
;
4.
A
parallel
procedure
is
used
to
calculate
Broker
PAEG/Ls,
which
benchmark
costs
from broker
release
through execution
based
on
the
most recent
quarter's
data.
What
Are
The
Strengths
OfThe
Database?
Probably
the
greateststrength
is the
diversity ofsample
trades.
The
sample runs
the
gamut
of
institutional
tradingfrom
the
simplest
to the
most
comolex.
lt
includes
trades
from
hundreds
of
managers,
traders,
and
brokers,
all
striving
to
produce
"best
execution"
and
maximal
performance.
lt
is
an
unbiased,peer-basedtotal-cost comparative standard.
The
second
strength
is the
number
ofobservations:
over
a
millionorders
go
into
the
computation
of
U.S.
PAEG/Ls eachquarter,
and
over 300,000 orders are used
in
the
computation
of
non-U.S.
equations.
Each observation contains
+lr^ .l^+^ +^ m^^^!rra aaa*a f.^*^^:^+-r.--rr-ti-tl l('(lcll,cl ((J
I
llEdDUlYtJtJ>l,Dllt/r
|
|PUilr!\JrPvr!rvllv
manager inception through
all
partialcompletions.Finally,
we
go
to
extraordinary effortsto scrub the
data
to
avoid
the
GIGO
principle.We
estimate
that
we
spend
2-4
man-years
per
quartervalidating
the
data submitted
to
us.
 
Factor
Interpretation
Co-efficientStandardErrorT-test
Intercept
Absent any
other
factor
effects,
transacting
is expected tolead
to
costs.-62.392.54-24.5
MomSize
Market
buy/sell balance
effect,measured as
the
product
ofthe
size of
the trade
and
the two davprice
momentum.-4.230.023
182.0
PercVol
Liquiditydemand,
measured by
the
percentage
of
dailyvolumethis
trade
reDresents.
-0.53
0.0'18
-29.4Size
Size
of
the trade.
in shares.00406220.0000030-20.6
LogCap
Log of
the
Capitalization
of
the
company8.29
0.6113.6
SizeDummy
A
small-trade
dummy
factor
equal
to
1
if
the tradeis
under10.000shares
17.i3
0.99
17.4
WhatDoes
a
Typical
PAEG/L
Equation
Look
Like?
The
PAEG/L
equation
is
estimated
separatelyfor
!.1'
qrr
rrccall nrr.{nr^ih
li.:+4/.1
qtanlzconr{
hr rrr
trceall
orders
in
NASDAQ
stocks.
Theequation
above
is the
Buy/listed
equationapplied
to
the
fourth
quarter
of
2004.
A
parallel
set
of
equations
evaluates
broker
executions.
In
addition,
we
calculate
separate
PAEG/Lequations
each
quarter
for
Canada. Latin
America,
Europe
(ex-
UK),UK,
Emerging Europe,
Japan,
Asia
(ex-
Japan),
and
Emerging
Asia,
P/ease
lnterpret
The Factors For
Me
.
The
Intercept is negative:
in
the absence of
any
otherfactors.the expectation
is
that transacting
will
lead
to
costs.
.
MomSize captures
the
movement
of the
stock
and
provides
a
measureof the degree towhich
the trade
is
liquiditydemanding
or
supplying.
Risingoricesduring
a
buy
execution
is
an
adverse situation, so
the
coefficient should
be
negative.
PercentVolume
is
a
measure
of
relative
trade
size.
We exoect
that
it
will
be more difficult
to
find
the
other side of the trade
for
highlevelsofPercVol,
so
its coefficient
should
benegative.
Largeorders
are
moredifficult
to
transact
and
should
imply
higher
costs,
so
the
Size
coefficient
is
also
expected
to
benegative.
Log Cap
is
a
proxy
for
stock
liquidity,
so
it
is
expected
that
it
should
have
a
positivecoefficient.
Trades
less
than
10,000
sharesare
easier
to
execute,
so we
would
also
expect
a
positivecoefficient for
the
Small Trade Dummv factor.
The
T-Test column shows
that
all
factors
are
significent
at
the
99%+
!eve!.
l-lcv;ever,
the
explanatorypoweris dominated
by
the
MomSize
factor,
which
reflects
the
compounded
effect
of
tradingIargeorders
into
stronglyfavorable
oradverse market
conditions.This
is
the situation
in
whichtradesaremost
likelv
to
be
costlv.
Is
the
Equation
StatisticallySignificant?
The
table
below
compares
the
in-sampleexplanatorypower
of
the
equations developed
on
second
and third
ouarter
2002 data
to
thepredictive
power
as
appliedinthefourth
quarter,
2002.
Remember
that
the
equation
is
tuned
for
maximumforecasting
power
(the
second
column.)
We can easily comeup
with
better
R-
squareds for
the
in-sample model,
but
the
powerderives
from over-fitting and
is
spurious.
For the
four
equations above,
the
deterioration
as
wemove
out of sample
is
about
25%.
PAEG/LequationIn-SampleExplanatoryPowerNextQuarterForecastingPower
ru/v
"09'i4Listed Stocks
-
Sells
1
130
.0848NASDAQ Stocks
-
Buys
.1202
0913
NASDAQ Stocks
-
Sells.1236
0778

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