October 25, 2005

The next innovation in TCR will help bring buy-side traders and portfolio managers together by measuring the efficiency of their interaction. First, it is critical to understand where in the process the transaction costs are being incurred. Calculating where costs were incurred and why they happened requires time stamps and price points for each of the following events:

  1. Investment decision.
  2. Order hits the buy-side trading desk.
  3. Order is routed to the sales trader.
  4. Order is partially executed.
  5. Order is completed.
If the transaction cost occurred between Point 1 and Point 2, it may be that too much time was taken between the investment decision and the order being sent to the desk. However, if the transaction costs occurred between Point 3 and Point 5, it may be related to a sloppy execution (see Exhibit 2, page 50). Today, only a small portion of investment managers actually measure transaction costs from the time the investment decision was made. However, as the technical hurdles in capturing time stamps are overcome, TABB Group projects those numbers will increase over the next two years.

TCR now will be able to track which portfolio managers and traders incur more or less implicit costs. Are transaction costs relatively constant for a particular portfolio manager, or do the costs change depending on the trader? Once a buy-side firm knows where transaction costs are being incurred, it can begin to implement various steps to reduce those costs. At a minimum, it shows the portfolio manager and trader that they share the responsibility for successful implementation. TCR is not just bridging walls - it is lowering the walls.

As much as traders want TCR to help assess broker value and increase efficiencies, perhaps their main focus is producing more-actionable data. One of the main complaints about the information today is that it is not rich enough. For example, if a buy-side trader puts in a multiday VWAP order and, on the second day, a slew of upgrades comes out and the stock spikes, causing the buy side to buy at higher prices, the buy side wants the TCR information to indicate that an upgrade had taken place while the order was live.

With pre-trade analytics, TCR is increasing the amount of information that flows throughout the entire investment process. Pre-trade analytics consist of data such as the estimated cost, volume, volatility and other stock characteristics. Currently, pre-trade numbers are being discussed by the portfolio manager and trader as they choose a trading strategy. Some buy-side firms are using the estimated cost to calculate a trading benchmark. In an ideal process, the estimated cost, generated by a combination of actual historical costs and forecasting, will be incorporated into the alpha model. The output to the process includes the order along with the benchmark. As each execution is reported back to the trading desk, real-time monitoring will help traders identify outliers to help limit the transaction costs. At the same time, the historical data and broker performance databases will be updated in real time, allowing trends to be identified as quickly as possible. Finally, the broker performance numbers will feed the broker value and best execution processes (see Exhibit 3, below).

The future of growth of TCR will depend on the providers being able to develop products that meet the three functions outlined above: determining the value of a broker, measuring the efficiency of the organization and threading TCR throughout the investment process.

Our Analyst

Adam Sussman is a consultant with Westborough, Mass.-based TABB Group. He previously served as a senior product manager responsible for order management systems, routing and next-generation trading tools focused on the equities and options markets at Ameritrade.

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