Thaders, Brokers,and Money:T/te Past is YourPresent andFuture

Based on the research of Kumar

Venkataraman of Southern

Methodist University, Amber

Anand of Syracuse University, Paul

lrvine of the University of Georgia,

and Andy Puckett of the University

of Missouri

ith Wall Street bonuses under the spotlight, new

evidence on the performance of Wall Street trad-

ers offers more nuance. Trillions of dollars in stocks

are traded month after month in financial markets.

New research by Finance Professor Kumar Venkataraman of SMU

Cox and co-authors shows that if pension plans and mutual funds pay

attention to the cost of implementing ¡nvestment ideas, they can save

significant amounts of money for fund investors.

The choice of the trader - who you select to execute the order

- matters. Author Venkataraman says, "Trader who are ranked high

based on past executions perform well in the future. This is the clas-

sic evidence for trading skill. This is particularly true for brokers. So

broker selection should be based on past broker performance."

lntermediaries MatterPrior research has focused on the performance of money managers,

those at mutual funds, hedge funds and institutional plan sponsors.

However, there is little work examining the performance of trading

desks, who are responsible for trillions of dollars in executions each

year. Recent work by other researchers says that manager sklll ac-

counts for less ihan half of a mutual fund outperformance (doing

better than benchmarks) and that fund characteristics are more im-

portant. So, the authors ask: why would the fund be a source of rela-

tive performance? Can the trading desk be the explanation? Trading

costs have the ability to erode or eliminate the value added by money

managers. Porlfoìio managers rely on the buy-side trading desks to

implement their investment ideas. A trading desk can add value to

an ìnstitution's portfolio by supplying experlise in transaction cost

analysis.

56 marketsmedia magazine I july/august 2010

The study reports that the quality of implementation is as important

as the investment idea itself. The research establishes the importance

of trading costs for the performance of managed portfolios, mutual

funds and pension funds. lmportantly, it shows that performance

rankings of institutional trading desks and brokers persist over time

and contributes to better understanding of the value addltion of ìarge

broker/dealers such as Goldman Sachs or JPMorgan, or niche play-

ers, such as Freeman, Billìngs and Ramsey.

The study examines a proprietary database of institutional investor

equity transactions provided by ANcerno, a consulting firm that moni-

tors execution costs. The data contain approximately 35 million order

tickets that are initiated by 664 institutional investors. These trades

were facllitated by 1,137 brokerage firms over a seven-year period

(1999-2005), representing $22.9 trillion in trading volume. The data-

base is distinctive in that it contains a complete history of each order

ticket- each typically resulting in more than one execution, sent by

an institutional investor to a broker. The ANcerno database includes

pension plan sponsors such as CALPERS, the Commonwealth of Vir-

ginia, and the YMCA retirement fund, as welì as money managers

such as MFS (Massachusetts Financial Services), Putman lnvest-

ments, Lazard Asset Management, and Fidelity.

Brokers ranked as best performers sustain their advantage over

adjacent periods. The best brokers can execute trades with no ex-

ecution costs. Similarly, the best (buy-side) institutional trading desks

continue to outperform peers over adjacent periods. The best desks

execute trades at negative trading costs, suggesting traders can cre-

ate positive portfolio alpha through their trading strategies. The au-

thors find the results to be striking as the dataset contain difficult-to-

execute trades initiated by large investors.

The combined effects of the institution and the broker are eco-nomically large. For example, the tradrng cost difference between theIop 20"/" institutions trading through hop 20% brokers [top institution-broker pairJ and the bottom 20% institutions trading through bot-Iom 2O% brokers [bottom institution-broker pairl is approximately 1

percent. Thus trading costs significantly contribute to mutual fundperformance. The analysis indicates that almost half the differencein the cost to execute a trade can be attributed to the trading desk,s

choice of brokers, emphasizing the importance of broker selection.

The study says that trading costs were not driven by the institu-tion's investment style.

What the Best Do

The study identifies a set of trading decisions that are associated w¡thperformance.

o lnstitutions receiving poor executions specify low commission(or 'touch') execution venues, suggesting that they tend to focus on

explicit trading costs. However, this choice is sub-optimal and canultimately cost the institution. The savings in explicit commissions arenegated by higher trade execution costs.

. Simple strategies such as concentrat¡ng order flow with fewerbrokers help institutions receive better execution.

. Brokers who specialize by sectors or industries, generally bou-tique brokerage firms rather than generalists, tend to provide betterexecutions.

o Higher explicit brokerage commissions are associated with betterexecution performance. This is contrary to research on mutual fundwhere higher compensation to money managers (higher manage-

ment fees) is associated with lower fund performance.. Trading costs decline when the broker expends more effort in

working the order.. Well-capitalized brokers tend to provide significanily better ex-

ecution. Their capital, and the ability to provide a direct counterpartyfor difficult to execute trades, is a hard competitive advantage to rep-licate.

Disclosure to lnvestors and Regulationlnstitutional investors account for a large portion of stock ownershipand daily trading volume in financial markets. Understanding whatdrives institutional performance is of special interest to investors,

money managers, and regulators.

"Mutual funds should disclose trading costs along with the quar-

terly performance," according to Venkataraman. Currenily, they onlyreport expense ratios. He observes. "Similar to expense ratros, imple-mentation costs can impact fund performance and should be madetransparent." lnvestment management firms are advised to ìmple-

ment trade management processes that assess the costs and qualityof trades.

From a regulatory perspective, the study should inform regulatory

initiatives such as SEC Concept Re¡ease 57-12-03, which considers"whether mutual funds should be required to quantify and disclose toinvestors the amouni of transactions costs they incu¡ include trans-action costs in their expense rat¡os and fee tables, or provide addition-al quantitative or narrative disclosure about their transact¡on costs.,,

'Best execution' has been the subject of recent regulatory attentionunder U.S. Regulation National Market System (Reg NMS) and Eu-ropean Union's Markets in Financial lnstruments Directive (MiFlD).

ln defining 'best execution,' regulators in the U.S. have emphasized

the fiduciary duty of brokers and fund managers to obtain the bestvalue for the investment decision. Brokers provide a package of otherrelated services to institutions such as prime brokerage services, lpOallocations, and research. There's no way of measuring these poten-

tially offsetting benefits. "ln reality,'best execution'is hard to mea-

sure, " states Venkataraman.

Trading Costs and Mutual Fund RankingsTrading desks can contribute to positive outperformance for institu-tions. Venkataraman relays "Buy-side institut¡ons - mutual funds,pens¡on funds, and proprietary tradlng desks --{an save investors

money by using the best ranked brokers. ln fact, they have a fiduciaryduty to choose the best broker and our evidence indicates that they

are fa¡ling in their duty."

The cumulative impact of trading costs can dramatically affect thereturns to a ìong-term investor in a fund. According to the study,s

estimates, better trade execution processes alone can add an incre-mental 62 basis points to a mutual fund's annual return (even more

for high turnover funds). Paying attention to trade execution canmove the mutual fund several notches up the rankings tables andhelp maintain relative outperformance.

The cumulative dollar impact of trading desk decisions such asbroker selection is large: an approx¡mate calculation suggests thatannual trading cost reductions could exceed $l billion if institutionsroute their order flow to the best performing brokers instead of thepoorly performing ones.

"Performance of institutional trading desks: An analysis of persis-

tence in trading costs" by Kumar Venkataraman of SMU Cox School

of Business, Amber Anand of Syracuse University, paul lrvine of Uni-versity of Georgia, and Andy Puckett of University of Missouri, is un-der review at a top tier finance journal.

Research summary written by SMU's Jennifer Warren.

marketsmedia magazine I july/august 2010 57