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Building Betler Perf otmdnGe

COMMENTARY 80 APRIL 2OO4

TRADING TRUTHS
How Mis-Measurement of Trading Costs ls Leading lnvestors Astray

Some recently published data argues that large cap stocks are more expensive to trade on the
NYSE than small caps. In this Commentary, we debunk that theory by demonstrating that this
conclusion results from incomplete data and faulty logic. We also show that:
. lmplementation costs are much higher than those reported using VWAP measures;
. So-called "pennying" only accounts for a small fraction of the cost of trading, and
. Damning the specialist-" and floor brckers ie nn! an appropriate nor desen.,ed response.

A recent maqazine article' states in the sub-title that
'Blue chips now cost more to trade on the Big Board than
small caps do." lt goes on to state "The higher cost of
trading giant-cap stocks at the NYSE, compared with
smaller names, runs counter to the conventional wisdom
that large, actively traded stocks have lower transaction
costs than smaller, less liquid ones."
The author provides a table, (portions of which are
reproduced on the following page), that shows "Micro
Cap" stocks of less than $250 million capitalization
costing 0.5 cents De.:r share on the NYSE whi!a "Giant
Cap" stocks with capitalizations in excess of $25 billion
cost 1 .9 cents per sha,re The arlicle gets fairly breathless
about how 'iransaction costs on the Big Board are
actually higher for big, actively traded stocks than they
are for small, lightly traded stocks."
dangerous: it may lead to mis-identification of the
magnitude, source and relevance of transaction costs
and thus contribute to inferior oerformance.
We will develop three important points:
1. Using pennies per share as the metric ignores the fact
that small cap stocks trade at lower prices than large
cap stocks. When expressed in economic terms as
percentage of principal, this key finding is simply false:
liquid, large cap stocks trade at no
higher impact cost than smaller
stocks.
2. f he actual costs of implementing
investment ideas is in fact
significantly higher than the figures
nrrnted
Yvvrvv hcre Indced thc differences orroted here are
trivial, while true implementation costs are egregious
and much larqer than can be seen through the narrow
perspective of the Volume Weighted Average Price
(VWAP) comparison.
3. The damning of specialists and floor brokers on the
basis of thrs evidence is faulty logic based on faulty
measurement.

The article attributes this phenomenon in part to

pennying; .... NYSE specialists' and floor brokers
putative practice of bidding a stock up or down by one
cent and trading for their own accounts ahead of
investors."
The author recognizes that the finding "runs counter to
the conventional wisdom that large, actively traded
stocks have lower transaction costs." Indeed, it is
counterintuitive; fortunately, the finding is false. And it is
Measu ring Economic Costs
Cents per share sounds like a simple metric, but it only
works if the share prices are reasonably similar. For
example, a dime cost on a $100 stock is 0.1oh; on a
$10 stock, it represents 1.0% -- a big difference.
lSchack, Justin: "Trading Places;" Institutional Investor Magazine,
November 2003. Po B1-85.
The share price for NYSE listed stocks with capitalization The picture here is one of impact as a percent of traded
less than $250 million is about $7; for stocks in excess of dollars rising as market cap falls. Showing costs as a
$25 billion the average price is around $35. The table percent of principal traded shows the expected
below adjusts VWAP impact differences in stock price. lt relationship, even though the impact in cents per share
shows the expected relationship: large, liquid stocks are declines.
traded with less impact than smaller capitalization stocks.
The last column provides a partial
VWAP lmpact Measures VWAP lmpact Price/shr VWAP lmpact explanation of trade size effects:
cap f/shr ($) (basis points) the average trade in the largest cap
1A 66 group is almost 19 times the dollar
Giant cap ($ 2SA+; 35
Large cap ($se - $258) t.o ZY 5.8
size in the Microcap group. Other
Midcap ($1B - $58) t.J 20 6.5 things being equal, we expect large
Small cap ($2SOw - $ta) u.o 14 4.2 trades to cost more than small
Microcap $250M or less 0.5 6.9 trades. Things are not equal,
however, since large cap stocks are
VWAP defines impact as the difference between the far more liquid and therefore easier
average price in the trade being executed and the to trade. Thus the interplay of trade size and available
average price in the market during the day. Noie thet tho li^!i/.,1;+.., /.r^+^-q;h^.,r.a +r2^llro .-.nci nl*eTences i-
VWAP impacts in the above table do not net to zero, as liquidity are ignored by the VWAP benchmark, which
they would be if the game were one that pitted uses the same benchmark irresoective of trade size.
institutional buyers against institutional sellers. The
investors must be losing to someone else, specifically The Real Cosfs of Implementing
market makers and speculators. Specialists, market
makers, hedge funds, day traders, speculators, etc. enter
lnvestment Needs and ldeas
the market opportunistically solely to garner short term
So far we've identified cents oer share measurement as
trading profits. In the process they provide liquidity to
leading to erroneous conclusions between large cap and
investors.
small cap stocks. But there are hidden costs of trading
Institutional traders enter the market to implement beyond the impact.
investment decisions. They cannot be opportunistic
First there's the commission. The following table shows
traders; they have an agenda, a blotter of specific trades
to complete. Therefore investors pay speculators for the NYSE commission costs by capitalization group. The
provision of liquidity, leading to frictional costs in the cents per share commissions are fairly steady. Showing
range of five cents per hundred dollars traded (5 bp.)
the cost in basis points highlights the higher commission
costs of trading lower priced stocks.
A more inclusive alternative to the VWAP measure is
called lmplementation Shortfall. lt measures the change
in price from the starting gate, where the trader receives
the orcier, to ihe finish iine vyhen tne eniife iraoe is Giant cap ($ 25B+) 12 4.3
completed. lt answers the question: How much of the Large cap ($SA - $258) 15 +.2
potential return did I lose to the cost of implementing the Midcap ($1B - $5B) 20 A4
-. 1

trades? Small cap ($250M - $18 28 4.0

Microcao $250M or less 47 3.4
The costs below show figures for all buy and sell trades
for a sample of 89 investment managers during the Another hidden cost of trading is the cost of searching for
second quarter of 2003. liquidity. Liquidity search costs are real; they eat into the
research advantage
for stock purchases,
I mplementation Shortfall lmplShort lmplShort
lmpact Measures
and they cost real
lmpact: Price/shr . lmpact: Trade Size:
dollars on security
cap ($) (basis points) ($thou;
d/shr sales when orices
Giant cap ($ 25B+) 6.U 35 474 2,286 decline before
Large cap ($5B - $25B) 5.9 29 21.4 1,448 finding the liquidity to
Midcap ($18 - $5B) 5.2 20 27.5 744 comolete the trade.
Small cap ($ZSOtttt - $1B) 4.4 14 31.0 They occur because
Microcap $250M or less 2.6 7 35.4 119 institutional orders
are often too large to be simply presented to the market, VWAP has its uses, but analyzing trade cost data is
and it is difficult to search for liquidity without influencing notoriously tricky. When the conclusions don't match the
the price against your interests. When measured from intuition. one needs to be extra careful.
the starting-gate price, the search costs easily dwarf the
impact and commission costs, as the table shows. They
also show the expected relationship: smaller cap stocks Pennying.' Does this Data
are more exoensive to trade. Su pport the Accusation?
Search Costs NYSE Search Cost
cap (bp) Qlshr Now we turn to the assertion that the alleged extra cost
Giant cap ($ ZSa+; 42 4.4 for large cap trades comes from pennyinE by the
Large cap ($58 - S25B) 23 6.2 specialists. The estimates we have seen for the cost of
Midcap (S1B - S5B) 35 7.0 pennying are in the $150 million dollar range. The NYSE
Sma lcao rS250M - SlB) 58 8.3 Fact Book for 2002 quotes a dollar volume of $10.278
Microcap 5250\l or less tv 8.7 trillion We double that figure to account for the fact that
fr.^,^
LIIEIU ^ d^ h,,,/^r
5 UUYtrI d^^rU d^ JUIIUI
^^r'^- IUI UVEIY
^,,^-,,t^- Shafe SOld.
Note that searcl^ costs are nuch higher for the Microcap
Dividing $'150 million by this number comes to 0.0007
stocks. The trading rn these stocks is describeo as by
basis points or two hundredths of a cent on an average
appointment." The term indicates that the brokers and
Q?6 chrro Thiq nrn^llnts tc :a! ta\ltr 2o/" Cf the \1\AAP
specialists find the other sioe when no interest exists on
the flnor A e-n.trv n.o.ess or searehino for the other
Y' J Y
cost and is not large enough to account for the
side leads io h gn searci cosrs, Orce both buyer and difference in cost, Grven the current high sensitivity
.- - J'e-araf geo quarr ry a'0 srze. concerning specialist behav or, the offhand attribution to
aooarent rncact s smai . penryrng st'rkes us as careless and inflammatory.

In summary, the key to successful trading is to

manage the speed of execution Trade too fast
and your demands for liquidity will allow others
to profit from your urgency. Trade too slow
and the information edge you are trying to
, ," v
Fira -rades Ieno to be a much aroer noiron
J' \1 r^roran
'
capture may be discovered by othets, wiping out your
of the Ca '. vo rme. leadirg to a raL-,tology where the
trade s -easu'ed aoa nst itself. lf an nstitution were the advantage. Thus traders need to weigh the impact costs
only bu5,er for the Oay tne VWAP costs show as zero, no of urgently executed orders against the search costs of
matter ,',^at rtre orice act o.r o't"e stoc< drring the day -ore passive trading techniques. VWAP, properly
expressed in economic terms. gauges only the impact
Add inn I rvqvr u I costs. T ming is de-emphasized. A trader judged solely
comnnntr^-c a.q t-tr tn,n\!.r- r:h e nr tntgl 6631- againsi a VWAP standard could avoid impact and
transfer the costs into the search cost
Total lmplementation I mplementation Shoftfall Volume Weighted category. thus fooling his evaluator and
Costs Total Averaqe Price possibly himself.
voP (bp) f/shr //chr
o As Mark Twain said, there are three kinds
Giant cap (S 25B+; +J 14.8
^{ li^^.
u llub, r;^^
ll9>, l^-^^.J
udllllluu li^-
llu>J anal DLdlrJUUs.
dllu a+a+ia+ino
Large cap rS5B - 525B; 60 to.+ LO
Midcap (S1B - 55B) 83 to.o LJ
More charitably, as was said in the movte
Small cap (S250M - S1B; 117 to. / 0.6 State And Main, "lt s not a lie, it's a gift for
Microcap 5250M or less 201 14.6 0.5 fiction."

The relationships are as we expect: small cap stocks are

more costly to trade when measured in economic terms
as percent of principal. In cents per share, costs peak in
the Midcap range, but this is an artifact of the share price
falling faster than the costs are rising for sequentially
smaller capitalization catagories. The VWAP
- repeated
from the first table - ignores the hidden search costs and
understates the real costs of trading. lt also reverses the 2 Readers familiar with the Plexus Group "iceberg" of costs will notice
cost to capitalization relationship. that we exclude opportunity cost in this article,