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Melting Icebergs

Melting Icebergs

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Published by Wayne H Wagner

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Published by: Wayne H Wagner on May 05, 2009
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06/16/2009

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grolfP,
Building BellerPerf ormdnGeCOMMENTARY
82
DECEMBER
2OO4
MELTING
ICEBERGS
lnCommentary68 ofOctober
2001,
we
noted
that transaction cost
icebergs
were
drifting,
but
the
advent
of
decimalization
and
a
changing
marketenvironment
made
thedirection
a
tough
call.
Early indications
were
towardslower
costs,
but
we feared higher
costs.
We were wrong!
The
obviousquestion
is'what
happened?'
We
identified threeoossiblesources
of
lornrer
costs:
.
changing market
technology
-
making
buyside
desks
more
efficient
and
reducing
brokerage costs,
.
changing market structures
-
decimalization
has
reduced impact
without
increasing liquidity
search
costs,
and
.
changing buyside behavior
and
composition
orders have much less
momentum
and
are
more
liquid,
and despite
therise
in hedge
funds, volatilityis at an 8year
low.
All
three have
contributed
to
lower
costs
and,
consequently,
to
lower
PAEG/L's@.But
we see
signs
that costs are
flattening.As
money
flows back
into
equities
and starts
moving
from
sector
to
sector
the
trend
may
change once
again.
Stay tuned.
,
u
o
---"*l1l',1!t
19::'9:91
r'*rg*'
t:
*
Timlng
.
lmpact
Comm
The
obviousquestion
is:
"what
happened?"
We
identified
three
possiblesources
of
lower
costs:
1l
changing market
technology,
21
changing
market
structures,
and
3l
changing buyside behavior
(and
composition).
We
will
discusseach of these along
with
their
possiblecontribution
to the
overall cost
drop.
We
willthendiscuss what we arecurrently seeing
-
and
try
to
providesome'auguring'
into
what
costs are likelyto
do
in
the
near future.
Changing
Technology
oo
-6
o
(,
o
g
p
g
The chart
below
shows the
dollar
weighted
trading
for
US
LargeCaptrading
between
2000
andcosts
ZVUJ.
\4/e
recentlysent
al!
clients a
copr"
of
the
Plexus-sponsored report by
the
Tabb Grouo entitled
"lnstitutional
EquityTrading
in America:
A
Buy-
Side Perspective."
(Available
on
www.plexusgroup.com.) The
report
reviewed
the
changes occurring
in
Costs
fell from a
high
of 122bp
in 2000 down
to 58
bp
in
2003(a
64
bp
or
52o/o
drop).
More importantly,
tradedreturns
net
of
costs
rose nearly
+50
bp,
showing thatreducing costs
had a
positiveimpact on
returns.
The
cost drops were similar inpercentageterms for all Market
Caps,across Largeand Small desks, andacrossother
Regions.
technology and how those changes
are
impacting
buy-side
traders.
The
keypoints:
1.OMS systems have reduced
the delay
between
the time that orders
hit
the desk
and
the
time
thattraders
can
actually
start to trade.2.FIX and OMS connectivityhas improved routing
of
smaller
or
very
liquidorders
for
automated
execution
-
allowino traders to focus
on
the
laroer
 
orders
where they
can add value.
3.
Aggregation acrossmarkets/ECN's has
improved
access
to
liquidity
-
and
more
than offset
the
reduction
in
dealerliquidity due to
decimalization.
Further,
capturing
a
montage
on
markets
may
actually improve
information
that was
lost
when
markets
became fragmented.
4.
Algorithms
-
disciplinedtools
-
ensure that traders
work
orders
inan
efficient
and
relativelv
inexpensive manner.
Algorithmic
trading
holdsgreat promise,but appears
to
be usedprimarily
by
hedge funds, brokers, and
a
small
handful
of
traditional
buyside
firms.
Mostbuy-side
firmscontinue to use MOC, MOO,
or
VWAP strategies; with
the
primaryemphasis on accessingliquidity
rather
than
cost
minimization
Surprisingly,
we don't see
cost differences
yet
between
clients
using sophisticated algorithms
and
those who trade more
naively.
Small desks
routing
orders
to
brokers
had
just
asgreata cost drop as
those
with
sophisticated
strategies.
While
this
may
change
over time,
the
biggest advantage of technology
appears
to
be making buy-side tradersandbrokers more efficient.
50
so-L
ro
l-
0
2002
*
Comm
ri.'i':
i.E
i
i'r=i",:,
;:,*;But even as explicit commissions rose,increased agency
trading
led
to
broker impact costs falling at aneven faster
rate.
On
a
combined
basis,
brokerage(impact
+
commission) fell from 55
bp
to 35
bp.
For
small caps,
the
drop
was
evengreater
(84bp
to
54
bp), but
for
MicroCaps
(.
$SOO
MM),
the
drop is only from
77
bp to
68
bp.
In
these cases,
penny
commissionsadd
up.
Changing
Buyside
Behavior
Perhaps
the
biggest contributor
to
lower
costs
is
the
change in buyside
behavior.
Oneof
the
most striking
is
the
reduction in manager and
analyst expectations.
As
a
result,
we see
less
chasingof new
market
favorites
and,
more importantly,
less
panicked
flight due
to
bad
earnings.
In
addition,
the
influence
of
retail day tradershas
been
greatly
reduced.
While
Hedge
funds,
the
new
wave
of
investors, have
become
a
significant
market
participant,
their
quant
orientation
has
not led
to
increased
volatility
(volatility
is at
an
8
year
low).
Managers
have
also
paredback illiquidholdings,
and
have
again
embraced
the
logic of diversification.
Changing
MarketStructureThe
biggest change
is
decimalization.We
looked
at
the
early
impact
in
2001,
and
found
that
despite
fears
to
the
contrary,
trading costs
were
already coming
down.
We
attributed
the
drop
to
much
lower intraday
volatility,
with the caveat that costs
would
likely rebound once markets became more
active.
And
we were right
-
but
for
only
a
short
period
of
time.
lmmediately
following
9111,
and again during
the
lraqinvasion,
trading
costs did rise,
but
they fell again
in
short
order.
The
second significant
change
was
the
1997
Order
Handling Rule andthe
ATS
Act.
Thisopenedup
the
NASDAQ
to
both
ECN's
and
to
Alternative
Trading
Systems
(ATS's).The
result was an agency
alternativefor
the retail
investor,
which
in
turn attractedgreater
flowfrom
the
institutions.
lronically,
ECN's
and
ATS's
had
a
smaller
direct
contribution to the drop
in
costs than
we
initially assumed.
Their
percentageof dollarstradedgrew
from
about 8%
in.
2000
to
12o/o
in 2003,
lower
than
many
would
expect.Total
trading costs
for
this
class
of brokers
(includingthedelay cost
of
waiting
foriseeking
liquidity) fell from
-52
bp
to
-48
bp.
These
numbers
areslightly
better than
theoverall average
of
-55
bp, but eliminating the commission
advantage
(2(
vs
4-51) results
in
no
additional
cost
?rjil:ii:i
t',+1
;ri;i;rFi'
t+;l'
t$i+.'ii:J'i:F',':..iii,:--.=
$.
i:,i,i
.-g11;j,{.f
9,
{}fl}u.{r.:,T
'...X,j#f
.i1;+,.#i:-;:,
.T
:i".};E
ti:l..Z
i=+;ii
advantage
to the
buyside
from
ECN's.
However,
the
ECN numbers
are understated.
Many
traditional brokers either have
their own
ECN
or
use
other ECN
routers.
Full service brokers have been
the
early
adapters
of
ECN
routers,
and their use
between
2000 and 2003grewfrom
50%
to
59%
while their
costs
fellfrom
-114bp
to
-59
bp.
DirectECN impactis
muted,
but
ECN's continue
to
influencebuysidebehavior
and
force
traditional
brokers
to
keep
costs
competitive.
Commissions, surprisingly,
are
the
one cost
that
has
risen since
2000.
Thisis
a
consequence
of the
shift
towardsagency
trading
in
NASDAQ
plus
lower
underlying equityprices(theaverage dropped from
$43in 2000
to$26
in 2003).
Gommissions
Rise,Yet
ErckerageCcsts
F:ll
qoo
O
0o0
o
co
40i
2000
2001
s
lmpact
 
Changes
in
Desk Order
Characteristics
Avg.
Shares
%
Daily
Vol
2
day
l\/lomentum200068,400
39o/o2.O1o/o
200164,300
360/o
1.35o/o
2002
64,000
3OVo
1.12o/o
200360,400
31o/o
0.794/o
While
reducing
the
liquidity
demands
is
helpful,
the
biggest change
and
contributor
to
lower
costs
appears
to
be
the
drop
in
momentum.
As the
table
below reveals,
the
percentage
of
momentum outliers
fell
dramatically since 2000(AdverseMomentum
fell
to
8.8%
of
1Q04
orders).
While there has been
little
change
in
the cost
of
Adverse
momentum
orders,
the
1
8
percentage
point
reduction accounted for
47
of
the
64
bp
drop
in
toial
costs since
2000.
On
the flip
side,
the
buy-side also
gave
up some
of the captured
gains
for favorable orders. but the
effect
was
minimal.
':
'
;
..,...':..:
:j:t:
,.:.::
'1,:
';".
,,:1
,:
;
i
'i,
:-
'.:;"
:
Equally impressive
is the
drop in
the
cost
of
Neutral
orders.
The
next
table
provides
some more
perspective:
Ghanges
in
Neuiral Momentum Order
Size
& Costs
+250K50-250K<50K2000
2003
20002003
2000
2003% orders
O+'/a30
-/o
lo70
1A%
20o/o
zo-/o
Cost-168
bp
-84
bp
-93
bp
-50
bp
-49
bp
-29
bp
Twochanges stand out;
a
higher
percentage
of
small
orders and lower costs across
all
sizes.
We
don't
have
momentum
distributions
for
each
size cut,
but
the
average momentum fell 55%(to
1.22oh) in
the
+250K
set,..
by
610/o
(to
.66%)
in
the
medium
size and
by
62%
(to
.25o/o)
in
the small
trades.
These
numbersgo
a
long way
towards
explaining
the
cost drops.We foundthat
the
percentageof large orders bottomed
in
2Q03and have risen eachquarter
since.
Overall
costs
also
bottomed
in 3Q03, but
have remained
stable,
but
with
a
greaterdivergence
of
individualclient
results.
The
momentum/size/costrelationship
will
bear
continued
monitoring.
.,:
:'
What
Abtaut
OtherMarkets?
',,"
i,
',
t-,,
Most
of the
discussion above has focused
on
US
large
cap
stocks.
However,
we
saw
similar
cost
andcharacteristic
trends in
Europe and in smallercap stocks.
The first set
of
charts looks at
US
small
caps.
-c
attO
cE
o
F
2000
2003
*
Timing
2000 2003 2000
2003
:
lmpact
Comm
..:,;..:
-:.,.-i.:
:
.:":
::
Costs dropped across
the
small
cap
spectrum,
down50% in both
the
Mid/Small cap range,
and a
42o/o
drop
for
Micro
caps.
Like
the
Large Caps,
the
MidCap
($1
-
108)
cost droo reflects acombination
of
reduced
momentum
i.
i
i.i.,i,::,
and improved relative
liquidity.
Butonly
lower
momentum
helped
the Small
and
MicroCaps.And
the
MicroCap
drop
in
momentum
is
smallerthan
the
other cuts, consistent
with the
smaller
reduction
in
trading
costs.
The
net conclusion
is that
Midand Small Caps
have
benefited
as
much
as
LargeCaps in both
the
changingmarketplace,technology, and manager
behavior.
But the
MicroCap response
hasbeen more
muted
-
although
costs
are
down
42o/o
-
reflecting
the
reality
that
these
stocks
continue
to
march
to
different drummers.
Changes
in
Order Momentum
Adve rse
N
eutral
Favorable20002003
2000
200320002003
7o
orders31%
134/a
I
55o/o
eml
140
6%YCost-261
bp
-234
bp
-85
bp
-48
bp
i
+4
bp
Changes
in
Small
Cap
Characteristics
$1-108<.5u
AvgMom.
okDail,1
Vol.
Avg.
Mom.
%
Dail;,Vol.Mom.
% Daily
Vol.
2000
2.O4
OZ-/oZ.
JJ
109%2.22
198o/o
20030.89
44o/o
1.38
1O5o/o
t.o/
217o/o
2003
European EquityCosts /
Characteristics
TiminglmpacrComm
Total
Size($,000's)
2
day
Mom.
o/o
DailyVolume
EU
2.O4
62Yo
Z.JY
1O9o/o
2.22
198o/o460/o
US
0.89
44o/o
1.38105%1.67
217o/o31

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