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Should I Fire My Trader or Pay Him a Million

Should I Fire My Trader or Pay Him a Million

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Published by Wayne H Wagner
Factors to consider when evaluating a securities trader
Factors to consider when evaluating a securities trader

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Categories:Types, Business/Law
Published by: Wayne H Wagner on Jul 01, 2010
Copyright:Attribution Non-commercial


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SHOULD I FIRE MY TRADER OR PAY HIM A MILLION?Gary Karz and Wayne H. Wagner ITG Solutions Network
As quantitative assessment of the equity trading process becomes widelyaccepted, the natural question arises whether the computed “quality scores” of firms, desks and individual traders should influence trader compensation.Investment managers agree on the need fair, complete, and relevant tools toevaluate their performance. A Plexus Group survey updated in 2005, indicatedthat 65% of the firms surveyed considered trade cost analytics in determiningtrader bonuses, up from less than half two years earlier. While many variablesand nuances are involved,the trend toward less subjective compensation systems will continue. This followslarger industry trends around quantifying investment process and performance.Bonus policies reflect a firm’s philosophy on the role of individuals and teams.The structure of these policies should promote actions and behaviors critical toinvestment success. Bonus criteria should encourage accountability and a desirefor improvement while rewarding successful performance.Assuredly, trading is an important component of performance. Therefore tradinggoals and evaluations need to be related to contribution to investmentperformance. A fair and appropriate bonus system should combine measures of firm and fund performance with quantitative and qualitative measures of trader contribution.The Plexus database confirms the importance of linking trader compensation toprofitability and performance. The Value Added difference between a 25
percentile trader and the 75
percentile trader in a recent quarter (a sample of almost 400 traders) has narrowed to 23 bps. Assuming 100% turnover, thedifference in annual portfolio returns between an average and a great trader would be 46 bps. With 200% turnover the difference between an average trader and a great trader approaches one percent, certainly large enough to capture theattention of a chief investment officer.Let’s step into the mind of the trader. While some traders many be lazy,incompetent or corrupt,
these are not issues we’re concerned with here, eventhough such traders are not easy to ferret out. We’re focusing on the humanbehavior of traders who are doing the best they can under the circumstances. Allof their accumulated experience goes into each trade: how do I read the chartsand recent activity, who do I trust, how big a trade can the market accommodate,is it better to trade now or to wait, should I use an alternative market, etc. adinfinitum. With this in mind, the competent and conscientious trader chooses a
These terms will be clarified later.
way to complete the trade that has the highest probability of achieving the bestresult. Surely, this meets the definition of best execution, whatever the outcome.But we have a problem. How do we know that the trader is conscientious andcompetent? How does the trader know? We need some standards by which to judge. It’s not good enough for CIO’s and Compliance Officers to accept thetrader’s own statement that he is a good trader. Portfolio managers, who liveunder the performance gun every day, would have little tolerance for such anassertion.
What makes for a good measure?
An optimal implementation strategy requires coordination of portfolio manager,trader, and broker roles. Thus any incentive policy must [a] align these disparateinterests and [b] deal effectively with the fact that the responsibility for goodtrading performance is shared by manager, trader and broker.We can identify three characteristics that would be desirable in any measureused to determine trader compensation:
Most importantly, the measure most correlate highly with the primaryobjective of delivering superior performance to clients.
The measure must not be gamable. A clever trader should not be able totrade in a manner that produces superior scores without satisfying the primaryperformance objective. Nor should the evaluated person be able to alter or edit trading data records without supervision.
The measure must create a level playing field for all traders measured.Differences in external factors affecting trader performance, such as softdollar requirements, constraints placed by the portfolio manager, level of discretion available, work load, pairs trading, and many other complicatingfactors, may influence trading style, flexibility and recorded quality.We will return to the initial requirements shortly, but let us first point out theimplausibility of accounting for “all factors.” Three forces interplay: [1] theinability of the human mind to grasp any more than a few dimensions of complexity; [2] external constraints that affect the outcomes; and [3] theimpossibility of categorizing and recording all the information necessary toaccurately portray and contextualize every trading situation.
The typical trader’s primary lament about quantitative evaluation is that itoversimplifies the complexity of the task at hand. “What I do is more an artthan a science.” The trader’s world is assuredly complex and fraught withrandomness, uncertainty and downright deceit. Thus the trader cannot
understand everything yet must make decisions within a (very) limitedtimeframe. This situation, which Herbert Simon described as
bounded rationality 
, is one in which trading decisions are not fully thought through andare rational only within limits such of time and cognitive capability. This is afactor to consider, not a criticism. Indeed, we should marvel at traders’ abilityto make split-second decisions on incomplete or conflicting information.
An institutional equities trader typically sits between the portfoliomanager(s) and the market. We can presume that the trader will be free toapply his best skills when trading judgment are unfettered by restrictive tradeinstructions. Unfortunately, we live in a world where portfolio manager interference and institutional constraints cast a long shadow. Consider softdollars. When required in moderation, they can be satisfied with “no brainer”trades: moderate share amounts in liquid names while free of marketimbalances effects. If the level of soft dollar commitments encroach into moredifficult trading situations, they resulting constrictions will impinge on thetrader’s option to chose another trading route or venue.Are traders given complete discretion over trading speed, with the intent tominimize impact, or are the traders instructed to complete the order within aspecific period of time? In the latter case the primary question is finding theliquidity and impact is secondary. If the traders are instructed to get tradesdone regardless of the impact, they should not be penalized for lagging abenchmark that incorporates the results of less encumbered traders. And if the realized returns are strong, the instruction to trade quickly is appropriatesince improving portfolio returns should be the primary objective over minimizing trading costs.This issue is especially relevant to firms with historically strong short-termreturns – timely orders. Traders at firms with very timely orders might showcosts near or worse than the benchmark, but this may in fact representsuperior trading. These traders are fighting a head wind since they must tradequickly to benefit the portfolios. Traders working less timely orders can waitlonger and spread the orders out over longer periods to reduce the impactwithout worrying about the stocks moving away.
Finally consider the problem of data acquisition. To illustrate, think aboutorganizing an attempt to evaluate algorithmic trading. At the first level wemight evaluate the offerings broker by broker. At a second level, we mightidentify which algorithm was applied. At a more detailed level, we might wishto record the settings of the parameters that control the algorithm. The moredata we record, the more accurate the evaluation and the finer the distinctionsthat can be made. This data is increasingly being captured, and we shallundoubtedly see a number of interesting stories covering this area in theforeseeable future.

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