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Institutional Order Flow and the Hurdles to Superior Performance

Institutional Order Flow and the Hurdles to Superior Performance

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lnstitutional
Order
Flowand
the
Hurdles
toSuperior
Performance
Wayne
H.
WagnerCo-Founder
and
Chairman
Plexus
Group,
lnc.
Los
Angeles
Institutional
investors trade
in
the
same
markets
as
retail
investors,
but
typically,institutional
investors
work
with
muchlarger amounts
of
dollars
and
shares.These
large
trades
do
not
appear
to
be
cost-effective
when
evaluated
from various
perspectives,
which
raises
the
question:
Is trading
costrelated
toliquidity
demand
or
to
marketfrictions?
fflrading
can
be analyzed
on
a
micro level,
which
I
is
what
transpires
on
a
trading
deskon a
day-to-day
basis.
My
presentation,however,
will
consider
trading
from
a macro
level-what
themarkets
are
like, the overall
viewpoint of
institutional
trading,
how
market structure
affects
trading,
and
howwell
managers
can
control
costs.
Example
of
a
Large
Institutional
Trade
To
a
retail
investor,
the
market may
seem
like
a
vend-
ing
machine: One
walks up, puts
in
coins,pushes
a
button,
and
walks
away
with
the
selected
stock.
But
that
is
certainlynot what
the
market
looks
like
to the
institutional
trader.
Considerthis real-life
institutional
trade. On
21
November
2002
aI8:50
a.m.,
a
portfolio
manager
for
a
large
momentum
manager
sent
his
trader
an
order
to
buy
7,745,640
shares
of Oracle
Corporation
stock.
The desk
fed that order
to
the trade
managementinterface,BloombergB-Trade,
one of the severalelec-
tronic
communications
networksGCNs)
available
to
the
trade
desk.The
trading
began
at
9:53
a.m.,
slightly
longer than
an
hour
after
the
order
was
received.
The
order
was
completedin
51
minutes
with
1,014
sepa-rate
executions;
the average
execution
size
was about
1,700
shares.
That
1,700
number
is
significant,
as
will
be
shownlater. The largest single
execution
was
63,877
shares
in
a
cluster
of
a
total of
190,000 shares
Editor's
note:
T}rispresentation
wasgiven at
the
preconference
workshop.
02003,
AIMR@
thattraded
within
one
minute.
The smallest
execu-
tionwas
13
shares.
In
this ordet,
17
percent
of
the
executions
were
for
100 shares
or
less;
44
percent
were
for
less
than
1,000 shares.
Thisorder
went
through
with
up
to
153
executionsper
minute,
faster
than
any
human could
handle.
On
that day,
Oracle
traded
59
million
shares,
andthis
1,700,000
orderrepresented
less
than
3
percent
of
Oracle's
tradingvolume that
day. Oracleopened on
21
November
at
$10.86
per
share.
The average
price
of
executionwas
$11.01.
After
this
orderwas
com-
pleted,the price
rose
to
close
at
$11.46.
The
cost
of
delay
plus
marketimpact, the
difference
betweenOracle's
price
atthe
time
theorder wasreceivedandthe average executionprice,
was
14
cents
a
share.
A
per
share commission
of
a pennywas
charged
in
addition
to the delayand
impact
cost.
Overall, this
appears
to
be
a
fine
trade.The
loss
ofprofit
between
whenthe
portfolio
managerwanted
to do the
trade
and the
time it
was
completed
was
15
cents.The
performancegained
from
the
aver-
age
price
of
execution
to
the
close
thatday
was
roughly
45
cents.
Thus, the
ratio
of
the
benefit
ofthe
order
to the
cost
of
completingit
was threeto
one.
TheMeat-GrinderEffect
The
Oracle trade
shows
that
it
is
possible
to
completelarge
illiquid
trades
bothin
the
central
market
and
in
the peripheralECN-like
markets.
But
even
in
this
case,
a
1,000:1
reduction
from
order
size
to
trade
size-from
1,700,000
shares
to
7,700-was
needed
toexecute
the
order.
Thisnumber,
7,700 shares,iust
www.aimrpubs.org
o
13
 
Equity
Trading:Execution
and
Analysis
happens
to
be the
averageexecution
size
on
the
NYSE.
It
also
happens
to be
roughly
the average
trade
size
on
Nasdaq.
This
average
execution
size
is
tiny
compared
with
the
size
of the orders that most
insti-
tutional
traders
handle
on
a
daily
basis.The
result
is
what
I
call the
"meat-grinder"
effect:
Large
trades
have
tobe
disaggregated
into
a
series
of
smaller trades
for
execution.
If
thesmalltrade
size is
the minimum
matched
size
between
the
averase
buyerand
the average
seller,
then institutional
trai-
ers
are
dealing
in
a
retail-structuredmarket in
which
the
institutions
tiptoearound
the
periphery
lookingfor trading
opportunities.
Alternatively,
the
smallertrade
size
could result
from structural
elements
in the
operationof
the
marketplacethat
force trades
to
be
brokendown for
execution.
Think
of
the
situation
this way: To
get
a
1,700,000-share
trade
done,
it must
be
forced
through
a
constriction averaging
1,700
shares
wide.
This
pro-
cessstretches
out
the
time
needed
to
execute thetrade.
Meanwhile, information
is
leakingslowly
into
the marketplace,
drawing
the
prying
eyes
of
dealers
and other market
insiders.
The resultingdelay
in
executingthe
order
translates
into
a
search cost
that
raisesthe
effectivetransaction
cost
of
the
trade.
Such
a
marketplace is
neither
an
efficient nor
an effective
way to
transact.
This
inefficiency results
in
higher
capital
costs
to the
companiesissuing
stock and
lowerinvestmentperformance
to
investors.
Who
bene-
fits?-market
insiders
who
are
positioned
to
takeadvantage
of
the factthat buyers
in
size
have
diffi-
culty
meeting
directly
and
anonymously
with
sellers
in
size.
In
order
to
put
transaction
costs
into proper
con-text, managersneed to
know
the
true
costs
of
imple-
menting
their
investmentideas.
If
a
manager
correctly
anticipates
thather
idea
will
result
in
a
doublingof
value,the appreciation
will
more than
offset thetransaction
costs.
But
if
her averase
return
per stock
is
only
3
percent,then transaction'costs
can
overwhelm
the benefits
of
the
idea.Suddenly,
the
meat-grindereffect takes
on
extreme importance
with
today's
lowered
market
return
expectations andthe challengepresented to
outperform.
Frictional
costscan
negatively affect investors'ability
to
accumulate
financial
assets.
Therefore,
mar-
ketplaces need
to
assess
their
ability
to
providefacil-
itiei
that
are
fficient
(i.e.,
low
cost
from
an
operationalstandpoint),
deep
(i.e.,lowimpact
associated
with
the
accumulation
of
largerpositions), liquid
(i.e.,
low
delay
costs),
andfair
(i.e.,the
value
of
research
flows
'.
to those
who
do the research
rather than
to those
who
are able
to
interposition
themselves
in
the
market-
place). Today'smarkets
do
well
on the
first criterion
butnot
as
well
on theothers.
Finally,
as
the
AIMR
TradeManagement
Guide-lines
say,
the
costs
of
trading
cannot
be
evaluated
outside
the
context
of
the
value
of
tradingactivity
because costs are
incurred
in
exchange
for
anticipatedoutoerformance.l
The PlexusStudy
At
the
endof
2002,we
at
thePlexus
Group completed
a
study
of
transaction
costs.z
The
study
included
867,327
orders
from
the
fourth
quarter
of2001
and
the
first
quarter
of
2002,
an
up
market.
As
a
follow-up,
we
added
431,539
orders
from
the
down-market
sec-
ond
quarter
of
2002.
The data
came
from
thetrade
accounting
systems
of
93
moneymanagers
linked
to
order
records
in
their
order
management
systems.
Thus, we
knew when
the
portfolio
manager
released
the
tradeand
when and
at
what
average
price
the
trade was
executed.
Therefore,
we
could
measure
trading
costs
with
a
fair
degree
of
accuracy.
Institutional
traders
are
aware
that
the
distribu-tion
oftrade
size is
highly
skewed.
A
large
numberofsmall
orders is
mixed
in
with
far
fewer,
but
moresignificant,
largeorders.Toaccount
for
this
skew
in
our
analysis,
we sortedour entire
database
by
dollars
executed
from
the
smallest
trade
to
the
largest.Wethen
broke
the dataset
into five
parts
so
that
ench
part
representedthe same
numberofdollarstraded.
Because
each
of
these
five
parts represents the
same
number
of
dollars traded, investorsshould
be
equally
inter-
ested
in
the
costs
and
performance
of
each
of
these
groups.
These
groups,however,
are
quite
differentfrom
one
another.
At
Plexus,
we
thinkof
transaction
costs as
an
iceberg,
as
illustratedin Figure
1.
The
commission
(5
cents, or
17bps)
and
impact
(10
cents,
or
34
bps) costs,the
parts
of the iceberg above the
waterline,
are
obvi-
ous to investors.
What
might
not
be
obvious
are
the
parts of
the iceberg
below
the
waterline:
the
costs
of
delay
(23
cents,
or
77
bps)
and
missedtrades
(9
cents,
or
29
bps).
Notethat
the delay
costs are
by
far
thelargest
cost.
Delay
is
the
costassociated
with
having
to
push
a
large
order through that
1,700-share
orderconstriction,stretching
the trade
out
over
time in
order
tobe able
to
execute
it.
All
the
while,
informa-tion
is
leaking into
the
market.
In
ourstudy, we wanted
to
pinpoint
thecost
ofinteracting
with
the
market.
Thus,
we
did
not
include
the
cost
of
missed
trades or
commissions.
We
definedthe
cost
of
interacting
in
the market
as
the
average'TheAIMR
Tiade ManagementGuidelines
can
be
accessed
at
www.aimr.org
/
pdl/standards/trademgmtguidelines.pdf.
zI
would like
to
thank
Meei-Tsern
Jeng
and
A1iJahansouz
fortheircontributions
to thisstudv.
14o
www.oimrpubs.org02003,
AtMR@
 
Institutional
OrderFIow nnd
the
Hurdles
toSuaerior
Performance
Figure
1.
lceberg
ofTransactionCosts
Nofe:
Missedtrade
costs
average
130
bpson
B
percent of the
portfolio
and
are
expressed
in
termsof
portfolio
effect.
Source:Based
on data
from
Plexus
Group.
cost of executed
trades
less
the average
decision
cost.
Simply
stated:
Trade
cost=
Executionprice
-
Decisionprice.
If multiple
orders
in
the
same
stock
came
from
port-
folio
managers,
we
aggregated
the
orders
and
theexecutions
to determine
the
two
equation
variables,execution
price
anddecision price.
lmpactof
TradeSize. Themajorityof
ourana-
lyses
focused
on
the
first
subperiod-the
risingmar-ket.
The
importanceof trade
size
in
falling
markets
will
be
covered later
in
thispresentation.
Table
1.
showssome
of
our
data
for
this
first
subperiod,
the
fourth
quarter
2001
through
the
first
quarter
2002.
Note that
11
out
of
every
12
trades,
or
92.5
percent
of
the
shares
traded,
fell
in
the
firstquintile.
Theaverage
trade
size
in
this
quintile
was
2,000shares,
the average
dollar
amount traded
was
approximately
$50,000,
and the
average
trade
wasmuch
less
than
a
day's
volume
(0.4
percent).
Further-
more,
the average
trade
cost
little
to
execute
(11
bps).These
easy-to-completetradesrepresentthe
bulk
of
institutionaltrading
in
terms
of
number
of
ordersbeing
processed.
Incontrast,
80
percent
of the
dollars being
tradedwere
in
thesecond
through
fifth
quintiles,yet
thesetrades
representedonly
7.5
percent
of
the orders andexecutions.
The
fifth
quintile,
the
20
percent
of
the
dollars beingtraded
as
part
of
the
largest
trades,
contained
only
2,500
buys
and
sells.
The
average
trade
size
was morethan
2
million
shares,
and
the
average
trade
involved
more
than
$75
million
in
principal.
These
trades
constituted more
than
half
a
day's
volume,
andthe
costs
were
significantlyhigher
than
for
thesmall
trades
in
the
first
quintile.
The
larger
trades represented
only
1
out of
every
400
trades,
although
thecost
per dollar traded
rose
from
11
bps
for
the
smallest trades
to
90
bps
for
the
largest
trades.
That
cost
differential
is
determined by
the
trade
size
in
conjunction
with
the
marketenvironment
inwhich
the
traders
have
to
operate.
Thefollowing
question
then
arises:
Is thisdifferential a
liquidity
cost
proportional
to thetrade
size,
or
is
it
a
frictional
cost
proportional
to
the
length
of
timethat
these
trades have to
be
worked
into
the
marketplace?Noticethat selling
is
always
cheaper than
buying
except
forin
the
fifth
quintile.
These
large
sell
trades
typically
represent
situations wherebadnewsis
in
the
market
andthe manager isanxious
to
dump
the
stock.
Table
2
sorts
the
same data
another way.
Each
quintile
was
divided
into
percentiles
of
cost
distri-bution.
Remember
that
the95th
percentile
containsthose adverse
momentum
trades
inwhich
the
trader
is
buying
a
stock
that
is
moving
up
aggressively,
so
finding
liquidity isdifficult.
By
contrast,
the
fifth
percentile includes
those trades made
under
favor-
able
marketconditions,
as
when
a
trader
is
buying
a
stock
that is
falling in
price.
The
tableshows that
the
cost
of
execution
not only
increases
as more
Table
1.
Equal
DollarQuintilesinRising
Market:
Fourth
Quarter
2001
through
First
Quarter
2002
Percent
Average
Daily Volume
/"_^l: ^'^\\rrrsurar
r./
rade
Count
Shares
(000-median)
Dollars
(millions-median)
Bry
Seil
Trade-Size
Quintile
Cost
(bps-median)Bry
ell
ny
Bry
Sell
Bry
Sell
1
(small)
234
5
(large)
444,48522,9068,3401.303356,053
18,988
7,2773,7991,2090.054.82
1,3.74
31.8675.620.065.79
75.67
35.24
80.91
22754
776
393
430
851
923
2,074
2,1050.4
10.818.328.752.60.3
i
1.1
18.2
30.853.8
-11
-6
47
-36
-64
47
-81
-69
-90
-727
02003,
AtMR@
www.aimrpubs.org
o
15

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