An introduction to measuring trading costs - TCA

Transcription

1 An introduction to measuring trading costs - TCA Ofir Gefen, Head of Research & Liquidity Managment ITG Asia Pacific 20 Investment Technology Group, Inc. All rights reserved. Not to be reproduced or retransmitted without permission.

2 Agenda A look at trading costs in the India market Introduction to TCA What is TCA? Why is it important? Integrating TCA into the investment process Best Execution across the investment process TCA for fund managers TCA for the trading desk TCA to measure brokers TCA for compliance and management The essential TCA checklist 1

3 Costs (bps) So why are execution costs higher? Trading cost are 2 to 2.4 times higher then markets like Australia, Japan, UK or US 3-month rolling average Implementation Shortfall costs comparison Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec- 2 India Australia Japan UK US

4 IS Trading Costs (bps) % Value Traded in each group India average execution costs by market cap 200 Average I.S. costs by Market Cap 189 0% % 80% 70% % % 40% 30% 20% 20 % 0 20 Q3 20 Q4 20 Q1 20 Q2 20 Q3 20 Q4 Large Cap Mid Cap Small Cap 0% 3

5 Spread (bps) How does India measure up? spreads & volume Jul- 9 8 Aug Sep- Time Weighted, Turnover Weighted Spreads Oct- 6 Nov- Dec Jan- Feb Average daily volumes: ~ US$3.5b (75%-80% NSE, 20%-25% BSE) SG~$1b AU~$4b HK/KR~$7b JP~$15b Mar- Apr- May- Jun- Jul- Aug- 9 Sep- Oct Nov- 9 7 Dec- Value (USD) Billions Spreads: 8-bps are in line with some of the most advanced developed markets JP ~ 22 bps AU/KR ~ 24 bps HK ~ 30 bps Jul- Aug- Sep- Oct- Nov- Dec- India Average Daily Turnover Jan- Feb- Mar- Apr- May- Value Period Avg Volume Jun- Jul- Aug- Sep- Oct- Nov- Dec Volume Billions 4

6 Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- Jul- Aug- Sep- Oct- Nov- Dec- Value (INR) Volume Average order size & volatility India - Monthly Typical Trade Size 16, , ,000 60, , , Average trade size is about 30 shares typical to a retail / electronic market KR ~ shares AU ~170 shares JP ~ 300 shares 4, ,000 0 Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Value Mar- Apr- May- Volume Jun- Jul- Aug- Sep- Oct- Nov- 0 Dec- Market volatility is around 23% SG ~ 18% AU ~ 22% JP ~ 19% US ~ 24% 35% 30% 25% 20% 15% % 14% 12% 12% % 18% NIFTY Annulized 30 Day Volatility 15% 19% 27% 18% 19% 17% 17% 23% 20% 31% 25% 23% 21% 5% 0% 5

7 What can be done about costs? You can t manage what you don t measure TAXES COMMISSION SPREAD MARKET IMPACT DELAY Commission costs 14bps (22%) Implicit (Hidden) Costs 50bps (78%) Delay Cost Timing Gain/Loss Market Impact Opportunity Cost What are trading costs? The difference between the price when the decision to trade was made, and the average price of executing the order (a) Explicit / Visible costs such as brokerage/commission fees and taxes only 20% (b) Implicit / Hidden costs including market impact and delay (timing costs) costs around 80% Source: ITG s global trading cost review available at 6

8 Using TCA to measure costs Transaction Cost Analysis (TCA) - Goal: Define where unnecessary or disproportionate costs arise - Measuring and analysing the factors which affect the price an order is executed at - TCA is an important part of the ongoing feedback loop to measure trading costs, so that they can be reduced - Involves taking time-stamped data at various points through the investment and trading cycle, and comparing it to the price of the asset in the market at the time, as well as an overall benchmark for the trade - Daily post-trade reports are only one aspect of this analysis, measuring the cost of trades over a short horizon. Longer term TCA reports take a more holistic view of the broader investment cycle 7

9 Why is TCA important? Best Execution - Trading in the most efficient way possible in order to preserve alpha, reduce costs & improve fund performance - A process rather than a price Has a significant impact on fund performance - Absolute terms (dollars under management) eg US$24mm saving in 1 year for a $2bn fund - Relative terms (fund s performance against peers) a move of a decile in rankings by improving trading efficiency Focus area for industry practitioners and regulators globally - MiFID regulations (Europe) & RegNMS (US) mandate Best Execution - Many global pension funds & plan sponsors now require proof of trade cost management policies before investing with a chosen fund manager 8

10 What is the effect of these costs? Assume a fund with US$2bn AUM with 35% turnover annually: Trading Dollar value 35%*$2bln = $700mln Execution costs = AvgCost% * 2 * $700mln What would be the expected transaction cost to the fund in different markets: India Cost: $,900,000 Japan Cost: $6,020,000 United Kingdom Cost: $5,740,000 Australia Cost: $5,600,000 United States Cost: $5,040,000 Cost difference of close to $7mln per annum 9

11 Integrating TCA to the investment cycle Review performance on an ongoing basis and repeat process Measure costs and attribute to cause Decide on benchmark and TCA method Understand whether costs are normal or disproportionate As a broad rule: approximately 80% of trading costs come from only 20% of the trades Integrate Pre-trade Cost analysis into portfolio construction & Alpha decisions Make technology work for you select algorithms and/ or dark liquidity which suit your trading objectives Implement your investment decision using advanced trading tools and /or broker desks Evaluate, select and maintain brokers based on trade performance. CSAs can be used to pay for other services

12 Bid/Ask Size relative to daily turnover (bps) Some of the reasons behind India high execution costs Bid/Ask Sizes As % of Daily Volume (by market) Australia Hong Kong Japan India Market Cap Weighted Median Bid Size Market Cap Weighted Median Ask Size

13 Best Execution across the investment process 12

14 Where costs arise across the process 1) Fund Manager/ Investment Decision Timing Costs Momentum 2) Trading Desk The trade off between speed and market impact Algorithm performance Identifying outliers 3) Broker Impact Cost Value versus Volume 13

15 Manager timing costs in action a practical example Over 500bps of cost was incurred on this sell order The cause of the timing costs was phased release 3 separate blocks of orders sent over a week 14 A recommendation was made to give information about full order size to the trading desk to allow them to advise if prices were moving away, or choose to get done quicker. This could save US$0mm annually for the fund

16 Identifying outliers a case in point A thorough analysis of outlier trades ensures that poor performance can be addressed or justified Order duration of 1 month! In example 1, order was with the desk for over 1 month despite being only 19% of ADV. This was identified through consultation as problematic (limit imposed was too low) & addressed through communication between desk & PM 15 Buy order duration of 1 day but price then fell was it poor timing by the trader? In example 2, what looks like poor trader timing was found to be due to a news announcement the trader could have no control over not a persistent problem

17 Performance (bps) % Value Traded Broker Analysis Some brokers are being given a lot of the flow but not adding performance value Brokers Performance (Top by Value Traded) 40 % 20 % % 0 (20) (40) (60) (28) (44) 7% () (21) (47) 6% (4) () (14) 6% 5% (34) (43) ` 5% 5% (33) (39) (43) (44) (27) 5% (52) 4% (53) 4% 7% 5% 3% (80) (65) (77) (77) (66) (74) (63) 1% (0) Broker 1 Broker 2 Broker 3 Broker 4 Broker 5 Broker 6 Broker 7 Broker 8 Broker 9 Broker -1% Broker I.S. PTA Value Added Total Value % 16

18 TCA for Compliance Monitors prices and performance of all trades against multiple benchmarks & provides an important record to maintain an audit trail Required in some regions by regulation, this is an important component of best execution 17

19 The essential checklist for transaction cost analysis To get the most out of TCA your tools must : Analyse the complete data set to give you the full picture Capture time stamp information to measure leakage at each stage of the investment process Allow comprehensive peer group analysis Give you a choice of the best benchmark for your needs Enable frequent data analysis Be both tactical and strategic, integrated into the overall trading process This will enable you to identify problem areas and reduce trading inefficiencies and costs

20 Conclusions Execution cost matter Save Money! Improve Returns! Use Best Practices to help you cut cost Tools Pre Trade, TCA, Post Trade TCA framework

21 Questions? ITG Hong Kong Limited (ITGHK) is a Participating Organisation of the Hong Kong Stock Exchange, a licensed corporation of the Hong Kong Securities and Futures Commission and is authorised under the Hong Kong Securities and Futures Ordinance to provide dealing in securities and automated trading services (Licence Number AHD8). ITG Japan Limited (ITGJ), is a registered broker with the Japanese Financial Supervisory Agency. ITG Australia Limited [ACN ] (ITGA is a Market Participant of the Australian Securities Exchange and is authorised under the Financial Services Law to provide financial services in Australia (AFS Licence Number ). ITGHK, ITGJ and ITGA are subsidiaries of Investment Technology Group, Inc. (the ITG Group).These materials do not provide any form of advice (investment, tax or legal). Neither Investment Technology Group, Inc. nor ITG Inc. is a registered investment adviser and they do not provide investment advice or recommendations to buy or sell securities, to hire any investment adviser or to pursue any investment or trading strategy. 20

22 21 Questions? Appendices

23 What s in a benchmark? BENCHMARKS DISCRETE AVERAGE PRICE I.S VWAP PWP Open Arrival PDC Bid/Ask I-VWAP Full Day VWAP X% Participation EoT+ X mins Start to EOD Last Next Mid +X Mid mins 22

24 1) Fund Manager/ investment decision Typical costs arise when: Orders are released to the trading desk in pieces (phased release), resulting in timing costs Fund managers place constraints on trading desks (eg limit or participation constraints), reducing the options for trading optimally Adverse stock movements due to the timing of the investment decision erode alpha How TCA can help: Custom analysis is focused on the behaviour of the fund manager or investment decision Goal is to identify cost-generating trends and improve Desk/PM communication Report reviews short-term alpha (30 days) before and after implementation Looks in aggregate at stock selection alpha profile and The market momentum affecting order decisions Can be analysed by fund manager or by fund In practice: Recommendations can be made around order timing which can save millions of dollars on annual performance 23

25 2) Trading Desk Typical costs arise when: Performance is affected by trader timing decisions Trading style does not match investment approach Market responds to the order and moves away (market impact) Timing costs will be highly correlated with short term momentum How TCA can help: Focus of the analysis is on the trading desk Helps traders select the best tools eg high touch vs. low touch execution channels Fits the specific stocks alpha profile to trading strategy Looks at high cost trades to see if any lessons can be learned In practice: Enables the trading desk to operate as a value added function, not just a cost centre Specific trading decisions and strategies can be reviewed to eliminate costs or improve processes 24

26 Broker Analysis Focus of the analysis is on brokers execution Help communication between trading desk and brokers Measures brokers impact costs Measures volume vs. value Brokers Impact Brokers are expected to execute over the time horizon of up to 1 day Brokers give rise to impact costs, but not timing costs Bring volume of trades sent to brokers in line with value they deliver The aim is to create a correlation between the amount of flow and performance Compare commission rates to peers Review different types of execution venues 25

27 Comparing apples to apples Problem: when comparing using Implementation Shortfall not all trades are created equal Demand for liquidity may be different Market conditions may be different Spreads may be different Solution: Create a handicap (much like golf) in an effort to equalise the field 1. Modelled approach ACE/Post Trade ACE Advantage: takes all relevant parameters into consideration Disadvantage: Model. Struggles at high ADV trades 2. Peer approach Advantage: real life trades comparison Disadvantage: complex, requires a large dataset 3. Average pricing for participate (PWP) approach Advantage: looks at the market over the life of the PWP horizon Disadvantage: ignores own trade impact 26