Yale Costs and Trading Bydomowitz

Transactions
Costs
and Trading
Ian Domowitz
Managing Director
Yale University, October 1, 2003 Best

Execution
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
Pre-Trade Analysis Trade Blotter Post-Trade Analysis

 Performance vs.
 Trading cost benchmarks
 Risk analysis  Trade data  Sorted and
 Optimal horizon  Organization organized
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
Components of Transaction Cost
2.00%
1.50% Market Impact

Opportunity Cost
1.00%
Bid/Ask Spread
0.50% Commissions
0.00%
-0.50%
Large Cap Value Small Cap Growth
*John Bogle Jr.. “Transaction Cost and Growth of Assets”

Will the Real Return (and Risk) Please
Stand up?
Trade Cost in bp 51 180
Turnover 600% 325%
Annual Cost 51bp*600%*2= 180bp*325%*2=
6.10% 10.80%
Gross Versus Net Alpha
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%
Trading Costs Impact Fund Rankings
Top S&P 500 Funds

3 Year Annualized Return
-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.
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
Measurement
 Trading costs are more than commissions and

spreads
 Implicit costs, including market impact, are
significant...
 But do not omit delay and opportunity costs
midpoint
BID ASK EXECUTION
Market Impact
Spread
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission COST 7
Measure Indirect Trading Costs
Paper Implementation Real

Returns Shortfall Returns
Returns if all Trades partially
Direct Costs
trades were or fully executed
executed Commissions, at prices
instantaneously Ticket achievable in the
and with zero charges,Taxes market, or not
cost at the executed at all
Indirect Costs
decision price
Delay Cost,
Timing Gain/Loss
Market Impact
Opportunity cost
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)
On Benchmarks
 So many choices, so much confusion
 What benchmarks to use?

 Miscommunication between traders and portfolio
managers symptomatic of benchmark issues
 Traders may perform well versus VWAP benchmark
 ...but portfolio managers are dissatisfied
 Pursuing a VWAP benchmark encourages traders to
parcel out their trades over several days, missing the
opportunity to obtain alpha
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
Original Order: Buy 100,000 INTL 1/10/01 10:46

Executed as follows:
1/10/01 30,000 @ $8.00
1/11/01 20,000 @ $8.75
1/12/01 30,000@ $9.50
1/16/01 20,000@$10.00
Benchmarks Results
Using Multi-Day, Order-Level

VWAP Benchmark
Cost is Negligible
But Using Decision Price

Cost is 14.25%
A Study in Timing
 The head trader believes costs are too high for

relatively liquid stocks
 Goal: identify the cost drivers
 The trade order management system has time

stamps for:
 When the order was released by the PM to the desk
 When the desk released the order to the broker
 When the broker executed the trade
The Scenario
PM Releases Trading Desk Order Received Exec Price

Order Places Trade By Broker (Actual)
Decision Price Delay Timing Gain/Loss Market Impact
Opportunity Cost (Slippage)
Cost 38 bp Cost 14 bp
Total Cost 52 bp
Overall transaction costs were 52 bp from

order release to execution
Costs from order release by the PM’s to the
Trading Desk equaled 38 bp per share
Costs from when the trade was placed by the desk
to the Broker were 14 bp per share.
Costs By Order Size / Market / Side
Trade Cost V. Benchmark (in bp)

OrderSize All Trades All Listed All OTC All Buys All Sells
0 - 99 (0.752) (0.588) (1.556) (2.096) 1.600
100 - 499 1.693 1.957 0.718 1.858 1.469
500 - 999 (0.292) 0.331 (1.795) (0.950) 0.519
1000 - 1499 (1.858) (1.185) (3.961) (2.750) (0.914)
1500 - 2499 (4.343) (3.368) (7.994) (5.706) (2.724)
2500 - 4999 (5.484) (4.470) (8.773) (7.065) (3.483)
5000 - 9999 (7.562) (7.396) (12.317) (9.664) (5.706)
>= 10000 (10.281) (10.435) (6.379) (10.651) (9.988)
Blue = outperforms benchmark

White = Underperforms benchmark by less than 5bp
Tan = Underperforms benchmark by more than 5 bp
Costs By Time Delay
Trade Cost V. Benchmark (in bp)

Time_Delay All Trades All Listed All OTC All Buys All Sells
1. 0 - 2 2.613 2.897 1.796 2.015 3.253
2. 2 - 4 (1.957) (1.072) (5.565) (3.391) (0.412)
3. 4 - 10 (8.758) (7.777) (15.111) (10.114) (7.216)
4. 10 - 20 (17.043) (16.596) (19.427) (16.135) (17.980)
5. more than 20 (6.083) (6.087) 0.505 (7.356) (3.811)

Costs By Time Delay & Order Size
Trades V. Benchmark Open or Sell/Bid & Buy/Ask (in bp)

1000- 1500- 2500- 5000-
Time_Delay 0-99 Shares 100-499 500-999 10000+
1499 2499 4999 9999
1. 0 - 2 0.888 4.297 3.902 3.613 2.767 2.200 1.180 2.560
2. 2 - 4 2.171 3.076 1.177 0.005 -1.162 (2.590) (4.720) (7.290)
3. 4 - 10 1.415 (1.103) (3.238) (5.095) -8.137 (10.220) (12.690) (11.830)
4. 10 - 20 -9.851 (1.484) (6.931) (11.112) -19.52 (19.470) (16.840) (27.230)
5. more than 20 -20.161 0.390 (0.484) (4.139) -9.502 (6.800) (5.550) (14.390)

Back to the Head Trader
 Not just large orders

 Timing study might suggest excess costs for
larger orders when sufficient liquidity was
unavailable
 Instead, presentation of a coherent set of results
elicits:
 desk has been holding small and large orders to package
together as part of programs
 the packaging has adverse consequences
 opportunity costs were incurred when the markets
moved against the trade
Measurement Visuals
 International fund manager implements a global

post-trade cost analysis
 Group trades by meaningful categories

 Market, Broker, Trader, etc.
 Visualization tools improved performance:

 Identification of problem trades in real-time
 Improved dialogue with brokers and traders
Identify Positions Needing Attention
Quickly identify potential trading cost “hot

spots”.
Review a heat map report of unfilled orders

before markets open to identify positions
needing special attention
Broker View
Analysis
 Building a narrative
 Aggregate pre-trade and post-trade trade results

by meaningful categories to see hidden costs
Periodic Reviews Add Value
 Head of Trading performs periodic post-trade

analysis to detect trends and refine investment
style
 Classify by market, sector, etc.
 Post-trade analysis indicates mediocre trading

performance
 Costs are 135 basis points overall, relative to an order-
level, mid-point benchmark
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
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
Average Daily Volume
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
_—

Outcome
 Improve trading strategy and performance by

synchronizing PM and trader goals
 Use implementation shortfall as the trader’s benchmark
 Incorporate this benchmark in the PM’s stock selection
process
 Traders incented to obtain target price close to

target price of the PM
 Traders may be willing to pay up in some cases to get the
trade done
 PM’s are more aware of the liquidity characteristics of
their trades and potential costs
Delay Costs
 Trader is concerned that his firm’s DOT

executions are too costly
 DOT flow is routed through one major broker

 From the time the trade was released to the desk to the
time of execution, costs averaged 35 basis points (buy-
ask, sell-bid)
 In dollar terms, this was about 9.5 cents
 Given the volume of DOT orders, this represents a
significant cost
 Should the broker be fired?
Decomposition
PM Releases Desk Places Broker Gets Executed

Order Trade Order Price
Desk Delay Time Delay Market Impact
Executed
Orders
Delay Costs = 26 bps
TIME
Total Cost = 35 bps
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.
 Broker has time it received order
 Of the 35 bps cost

 26 bps is attributable to delays/slippage
 Of which, 3 bps is noise due to time stamp mismatches
 9 bps is the cost
 Measured from when the broker received the order
 Benchmark is buy at ask, sell at bid
“9 bps is still too high!”
 Maybe
 Further analysis finds that some trades are sent

prior to the open
 Cost computation uses previous quotes, which

might be considered to be misleading
Illustration for Sell Order
Portfolio managers have a systematic tendency to generate

sell orders prior to open if market is likely to decline
Previous Bid (Benchmark for sell)

 Incorrect Attribution
of Cost (5 bps)
Opening Price 
Broker Executes at
Opening Price
9:30AM
Resolution
 For orders received pre-open, use opening price

as benchmark; otherwise buy at ask, sell at bid
 Results: Broker cost falls to 4 bps
 Outcome
 No change in broker
 Methodology adopted to measure other brokers
 Approach to creating program trades reviewed
Control
 The real name of the game
 Identify means of reducing price impacts
 Example: liquidity monitoring possibilities

 Larger sizes in an environment characterized by more
trades
 Larger sizes with smaller spreads
Liquidity States and Costs
Size
low high
low
Liquidity
high
Cost
Size
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
Logical Participation
Portfolio Order Book

& Market Data
Model
Horizo Order Submission

Desired Order n Venue
Characteristics Manag Size
er Timing
Horizon Managers
 Given a strategy,
trading over extended
horizons depends on
characteristics
 For a particular stock,

logical participation
depends on strategy
Different Stocks /Different Strategies
To Reduce Costs
AMGN: LNY:
AMGN & LNY Intra-day Volume Dispersion Volume Volume
18% Curve Curve
16% Bin Percent Percent

9:30 17% 11%
Pct of Daily Volume
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%
LNY: Volume Curve AMGN: Volume Curve

Spread Volatility
(bps) (bps)
AMGN 3 160
LNY 29 226
Trade Distribution Example
Aggressive: Passive:
high volatility, low volatility,
small high
percentage ADV percentage
ADV
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
Expected Cost/Shr (BPS)
Logical Participation Building Blocks
Smart Order Type Filters
Horizon Manager
Research Inventory
Modules Automated Order Types
SS1 SS2 SS3
Enhanced
Data Intelligent Order Router
Other Market
NYSE AMEX Crossing Trading Desk ECNs
Exchanges Makers
 Listed Destinations  OTC Destination
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
A Server for Horizon Trading
 Intelligent autopilot for

portfolio trading
 Continuously monitor
progress and urgency 100%
Bands define leeway for
Percent Completed

straying from the

50%
distribution in search of
better executions
Fills
 LOM analytics to price
0%
orders appropriately 9:30 Time Horizon 4:00
according to market
conditions
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
 Typical discretion order type errors

 excess time and effort required to make informed
discretion range judgements
 constancy of discretion range over life of order, although
aggressiveness should be a function of urgency, which
may change
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
Beyond Simple Pegs
 Blended passive/aggressive strategy for price

performance with on-time completion.
 Supply liquidity to obtain favorable fills
 Use carefully-timed aggressive orders to stay on
schedule
 Multiple electronic agents working in concert
Quoted Spread
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
Automating the Short Horizon
 Watch every name individually

 Update information continuously
 Forecast quote movements:
 Width of Spread
 Direction of Market
 Bid/Ask Volatility
 If the model predicts favorable market movement
 trade to capture a portion of the spread
 If the market looks to move against the order
 trade aggressively, based on the horizon
The ITG View of Logical Participation
Inbound
Client Orders
ITG
ITG Order Filter
SPI activePeg™ Horizon ITG Desk

Small Orders All Order Sizes Large Orders
10-240 min Time Horizon 30-390 min Time Horizon Expert Manual Attention
5-30 min Time Horizon
ITG SmartServer Family
DOT TriAct™ POSIT® ITG OTC Router
NYSE SuperMontage
AMEX ECNs / ADF
Regionals Market Makers
Controlling Pieces of the Puzzle Over Multi-
Day Horizons
Day 1 Day 2 Day N

portfolio risk portfolio risk portfolio risk
portfolio composition portfolio composition
residual risk residual risk
price behavior price behavior price behavior
trading costs trading costs trading costs
urgency urgency
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
The Typical Tradeoff Picture
Market Impact vs. Opportunity Trade-Off
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
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
S&P is a registered trademark of McGraw Hill Inc.

Short-term Long-term
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
Daily Risk Monthly Risk

S&P is a registered trademark of McGraw-Hill, Inc.
A Complementary View
 Two opposing forces

 reduce market impact
 reduce risk
 a portfolio that behaves like the target portfolio as soon
as possible
 With appropriate cost and risk models
 construct waves to implement the transition
 analyze tradeoff between predicted cost and risk
 same basic tools as the classical Markowitz portfolio
problem
 Example conclusion
 “no wave that completes 15% of the transition, while
costing 35 bps, will result in a tracking error lower than
7.8%”
Cost and Risk Tradeoffs
Efficient Frontier
Risk (% )
Transaction Cost (bps)
5 7 9 11
-20
-25
-30
-35
-40
-45
-50
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
Example
 This approach was recently used in a $1.2 billion

two-sided transition portfolio with 403 names
 Original portfolio has aggregate tracking error of 3.5%
 Transition instructions permitted the list to be traded in
“waves” subject to constraints
 Analysis shows can trade a 25% “wave” of $307MM that
cuts risk to 2.7%
 Trade 81 of the 403 names
 This wave improves liquidity of residual positions; order
size drops from 18.7% to 14.7% of average daily volume
 Successive application yields the optimal transition
strategy
A Final Note on Convergence of
Technologies
Execution Analytics Portfolio Analytics
Transition Tools
Trading Tools

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Transactions

Yale University, October 1, 2003 Best

Pre-Trade Analysis Trade Blotter Post-Trade Analysis

Components of Transaction Cost

1.50% Market Impact

*John Bogle Jr.. “Transaction Cost and Growth of Assets”

Gross Versus Net Alpha

Top S&P 500 Funds

 Trading costs are more than commissions and

BID ASK EXECUTION

Paper Implementation Real

 So many choices, so much confusion

 What benchmarks to use?

Original Order: Buy 100,000 INTL 1/10/01 10:46

Using Multi-Day, Order-Level

But Using Decision Price

 The head trader believes costs are too high for

 Goal: identify the cost drivers

 The trade order management system has time

PM Releases Trading Desk Order Received Exec Price

Decision Price Delay Timing Gain/Loss Market Impact

Opportunity Cost (Slippage)

Overall transaction costs were 52 bp from

Trade Cost V. Benchmark (in bp)

Blue = outperforms benchmark

Trade Cost V. Benchmark (in bp)

Blue = outperforms benchmark

Trades V. Benchmark Open or Sell/Bid & Buy/Ask (in bp)

Blue = outperforms benchmark

 Not just large orders

 International fund manager implements a global

 Group trades by meaningful categories

 Visualization tools improved performance:

Quickly identify potential trading cost “hot

Review a heat map report of unfilled orders

 Aggregate pre-trade and post-trade trade results

 Head of Trading performs periodic post-trade

 Post-trade analysis indicates mediocre trading

Order Size as a Percentage of Average Daily Volume

 Improve trading strategy and performance by

 Traders incented to obtain target price close to

 Trader is concerned that his firm’s DOT

 DOT flow is routed through one major broker

 Should the broker be fired?

PM Releases Desk Places Broker Gets Executed

Desk Delay Time Delay Market Impact

Total Cost = 35 bps

 Broker has time it received order

 Of the 35 bps cost

 Further analysis finds that some trades are sent

 Cost computation uses previous quotes, which

Portfolio managers have a systematic tendency to generate

Previous Bid (Benchmark for sell)

 For orders received pre-open, use opening price

 Results: Broker cost falls to 4 bps

 The real name of the game

 Identify means of reducing price impacts

 Example: liquidity monitoring possibilities

Portfolio Order Book

Horizo Order Submission

 For a particular stock,

16% Bin Percent Percent