Professional Documents
Culture Documents
Costs
and Trading
Ian Domowitz
Managing Director
ITG Inc., Member NASD, SIPC ©2003 ITG Inc., All Rights Reserved, Not to be reproduced without permission
91603-82599
Successful Implementation Strategies
Portfolio Management
Risk analysis
Optimization
Fair value pricing
Trading
Access to all
liquidity sources
Logical participation
trading strategies
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 2
Who’s Got the Alpha?*
Two funds:
Large Cap Value Gross Alpha=13.1%
Small Cap Growth Gross Alpha=17.8%
Both Incur Trading Costs
2.00%
0.00%
-0.50%
Large Cap Value Small Cap Growth
20.00%
18.00%
16.00%
14.00%
12.00%
Net Excess Return
10.00%
Transaction Cost
8.00%
6.00%
4.00%
2.00%
0.00%
Large Cap Value Small Cap Growth
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 4
Trading Costs Impact Fund Rankings
-9%
Top 25 funds
more pronounced: Next 75 funds:
-10% Average 8.5 bps Average 0.6 bps
% Return
between ranks between ranks
-11%
-12%
0 20 40 60 80 100
Source: Lipper
Rank
16 bps would move the #50 Fund to #20.
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Three Step Program
Measurement
Regular pre-trade and post-trade measurement
Focus on implicit costs of the entire trade
Analysis
Compare trades to appropriate benchmarks
Aggregate pre-trade and post-trade trade results by
meaningful categories to see hidden costs
Control
Trading as a source of value
Logical participation
Control the attributes of residual portfolios
throughout the execution process
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 6
Measurement
Market Impact
Spread
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission COST 7
Measure Indirect Trading Costs
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Types of Costs
Executed
B/O Midpoint Price
PM Decision Price Release Price at Execution time (Actual)
Delay Timing Gain/Loss Market Impact
Executed
Orders
Opportunity Cost
TIME
Opportunity Cost
Unexecuted
Orders
Executed
Price
(Assumed)
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On Benchmarks
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Typical Example
INTL (Inter-Tel)
10.5
10.0
9.5
9.0
close
8.5
8.0
7.5
7.0
1/10/01 1/11/01 1/12/01 1/13/01 1/14/01 1/15/01 1/16/01 1/17/01
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A Study in Timing
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The Scenario
Cost 38 bp Cost 14 bp
Total Cost 52 bp
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Costs By Order Size / Market / Side
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Costs By Time Delay
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Costs By Time Delay & Order Size
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Back to the Head Trader
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Measurement Visuals
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Identify Positions Needing Attention
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Broker View
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Analysis
Building a narrative
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Periodic Reviews Add Value
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Good News
Outstanding performance
0.8 on difficult trades
GBR
0.6
FRA
Predicted Less Actual Cost (%)
0.4 DEU
0.2
0
<1% 1.0-5.0% 5-10% 10-25% 25-50% 50-100% 100-1000% >1000%
-0.2
-0.4
Order Size as a Percentage of Average Daily Volume
Average Daily Volume
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 24
Bad News
0.8
Mediocre Performance
â … on liquid ‘lay-up’ trades
0.6
â ¸
Predicted Less Actual Cost (%)
0.4 â ë
0.2
0
<1% 1.0-5.0% 5-10% 10-25% 25-50% 50-100% 100-1000% >1000%
-0.2
-0.4
Order Size as a Percentage of Average Daily Volume
Average Daily Volume
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 25
Really Bad News
. h
Liquid trades dominate volume
. ¦
. å
Pct Trade Volume
¥ð
. # ¥
¥H
. a
8
x ù ¹ ù ùJ dù¢ ¶ùô ùL i ùð
_—
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Delay Costs
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Decomposition
Executed
Orders
Delay Costs = 26 bps
TIME
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Results of Decomposition
Approach
Obtain time-stamp from TOMS to figure out time when
order was first sent from the PM desk, client’s trading desk.
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“9 bps is still too high!”
Maybe
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Illustration for Sell Order
Opening Price
Broker Executes at
Opening Price
9:30AM
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Resolution
Outcome
No change in broker
Methodology adopted to measure other brokers
Approach to creating program trades reviewed
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Control
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Liquidity States and Costs
Size
low high
low
Liquidity
high
Cost
Size
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Price Impact and Upstairs Trades
16
14
12
10 Predicted
8 Actual
6 Cross
4
2
0
10 20 30 40 50 60 70 80 90 100
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Logical Participation
Model
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Horizon Managers
Given a strategy,
trading over extended
horizons depends on
characteristics
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Different Stocks /Different Strategies
To Reduce Costs
AMGN: LNY:
AMGN & LNY Intra-day Volume Dispersion Volume Volume
18% Curve Curve
14%
10:00 12% 9%
12%
10:30 9% 8%
10% 11:00 7% 7%
8% 11:30 6% 7%
6% 12:00 5% 6%
4% 12:30 5% 6%
2% 13:00 5% 6%
13:30 5% 6%
0%
14:00 5% 6%
9:30
10:00
11:30
12:00
13:00
13:30
14:00
15:00
15:30
10:30
11:00
12:30
14:30
14:30 6% 7%
15:00 8% 9%
Bin 15:30 10% 13%
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 39
Trade Distribution Example
Aggressive: Passive:
high volatility, low volatility,
small high
percentage ADV percentage
ADV
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Traditional Index Strategy v. Logical
Participation
1800
1587
1600
1400
1200
1000 920
789
800
600
458
400
200
0
VWAP ADR's ACE ADR's VWAP ADR & SPX ACE ADR & SPX
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Logical Participation Building Blocks
Horizon Manager
Research Inventory
Modules Automated Order Types
Enhanced
Data Intelligent Order Router
Other Market
NYSE AMEX Crossing Trading Desk ECNs
Exchanges Makers
Listed Destinations OTC Destination
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 42
Longer Horizons
Two objectives
match the desired trading distribution/benchmark closely
obtain favorable execution prices
Objectives achieved by
Placing and correcting limit orders to maximize
opportunities to earn the spread
Sending marketable orders as necessary to keep on
schedule
Design for large trade sizes in portfolio trading
applications
Next generation VWAP
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A Server for Horizon Trading
Percent Completed
according to market
conditions
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Pitfalls in Pegging and Discretion
Strategies
Typical pegging algorithm errors
contribute to momentum by instantaneously adjusting
price to match all quote changes
pegged orders typically leave an obvious information
trail
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Pegging and Discretion Revisited
Enhanced pegging
peg an order loosely to the inside market
react conditionally, determining whether each quote
change merits an order price correction
randomize and blend in with the crowd
Dynamic discretion
automatically choose appropriate discretion range for
each order independently
continuously adjust range over life of order, recalculating
the trigger price that demands liquidity
Adjust based on market conditions
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 46
Beyond Simple Pegs
One agent provides liquidity, pegging a piece Second agent trades opportunistically using
of the order loosely to the inside market. carefully-timed orders at marketable prices.
Discretion range adjusts dynamically
Objective: to maintain exposure to the based on current urgency level.
inside market without driving prices
or leaking information Objective: to complete trade on schedule
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Automating the Short Horizon
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The ITG View of Logical Participation
Inbound
Client Orders
ITG
NYSE SuperMontage
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Controlling Pieces of the Puzzle Over Multi-
Day Horizons
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Incorporate Risk
Use a pre-trade
model that
incorporates a daily
risk model to
quantify opportunity
cost
Find optimal strategy
to minimize impact
costs while balancing
delay costs
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 51
The Typical Tradeoff Picture
1.20
1.00
0.80
Minimum Cost Point
Cost
0.60
Market Impact
0.40 Opportunity
Total Cost
0.20
-
1 2 3 4 5 6 7 8 9 10 11 12
Time
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 52
The Right Risk Model: Horizon Does
Make a Difference
Short-termversus long-termriskof S&P500
1
0.9
0.8 Short-term
volatility can
Annualized Risk
0.7
0.6 differ significantly
0.5 from longer-term
0.4 volatility
0.3
0.2
0.1
0
19 01
19 10
19 07
19 04
19 10
19 07
19 04
19 01
19 10
19 04
19 01
19 10
19 07
19 04
19 01
19 10
19 07
20 04
20 01
20 10
07
19 01
19 07
85
85
86
87
88
91
91
94
96
97
99
00
00
88
89
90
92
93
94
95
97
98
01
19
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 53
Market & Specific Risk Matters More at
Daily Levels
RiskDecompositionof S&P500index
16.00%
14.00%
12.00%
Annualized Risk
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
Total Market Size Value Sector Industry Specific
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 54
A Complementary View
Efficient Frontier
Risk (% )
Transaction Cost (bps)
5 7 9 11
-20
-25
-30
-35
-40
-45
-50
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Where Risk Control Meets Cost Control
Benchmarking
Strategy
Max $ traded
Min dollars at risk
Min trading costs
Urgency
Control
characteristics
that add to
cost of trade
$ risk
Tracking error
Rights Sector
©2003 ITG Inc. All balance
Reserved, Not to be reproduced without permission 57
Create 20% value
optimized wave
to reduce
tracking error
while also
improving
liquidity
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Example
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A Final Note on Convergence of
Technologies
Transition Tools
Trading Tools
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