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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
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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”


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Will the Real Return (and Risk) Please
Stand up?
Large Cap Value Small Cap Growth
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%
Large Cap Value Small Cap Growth

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 4
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.

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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

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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

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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

 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

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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

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
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Benchmarks Results

Using Multi-Day, Order-Level


VWAP Benchmark
Cost is Negligible

But Using Decision Price


Cost is 14.25%

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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

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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.

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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

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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)

Blue = outperforms benchmark


White = Underperforms benchmark by less than 5bp
Tan = Underperforms benchmark by more than 5 bp

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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)

Blue = outperforms benchmark


White = Underperforms benchmark by less than 5bp
Tan = Underperforms benchmark by more than 5 bp

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 17
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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 18
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

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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

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Broker View

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Analysis

 Building a narrative

 Aggregate pre-trade and post-trade trade results


by meaningful categories to see hidden costs

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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

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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
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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
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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
_—

Order Size as a Percentage of Average Daily Volume


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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

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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?

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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

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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.

 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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 30
“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

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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
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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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 33
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

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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

Portfolio Order Book


& Market Data

Model

Horizo Order Submission


Desired Order n Venue
Characteristics Manag Size
er Timing

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Horizon Managers

 Given a strategy,
trading over extended
horizons depends on
characteristics

 For a particular stock,


logical participation
depends on strategy

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 38
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

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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

Expected Cost/Shr (BPS)

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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

©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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 43
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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 44
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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 45
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

 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

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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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 48
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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 49
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

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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

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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

©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

S&P is a registered trademark of McGraw Hill Inc.


Short-term Long-term

©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

Daily Risk Monthly Risk


S&P is a registered trademark of McGraw-Hill, Inc.

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 54
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%”
©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 55
Cost and Risk Tradeoffs

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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 58
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

©2003 ITG Inc. All Rights Reserved, Not to be reproduced without permission 59
A Final Note on Convergence of
Technologies

Execution Analytics Portfolio Analytics

Transition Tools

Trading Tools

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