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The Great Order Flow Debate

Buy-side traders are adopting more-sophisticated tools to measure execution quality and rank their brokers. The question remains: Do the top-ranked brokers receive the most order flow, or does the relationship reign supreme?

As transaction cost analysis (TCA) tools emerge on the desktop, buy-side traders increasingly are scrutinizing the quality of their executions - both to dissect their own trading performance and rank their brokers. But, while many firms use TCA to help direct their order flow, there are questions about the prudence of relying solely on these metrics to select brokers.

Meanwhile, the trend toward measuring execution quality is accelerating as buy-side traders take more control over their executions through direct market access (DMA) and algorithmic trading strategies. While there are regulatory pressures from pension plan sponsors and the need to comply with best-execution obligations from the SEC, it is, in large part, this shift in control from the sell-side block desk to the buy side's own trading desk that is driving the current TCA momentum.

"The buy side has so many options for trading - they can do DMA, algorithmic trading; they can use traditional markets through the sell side," relates Peter Bergan, senior consultant at Citisoft, a financial services consultancy that works with 75 percent of the top 50 asset-management firms. "They're using TCA to measure how they are doing as they continually tweak their processes," he explains. "Maybe an algorithm is the correct tool; maybe they need to adjust the setting to be more or less aggressive," Bergan adds. "They're also using the TCA tools to rate internal traders, as well as the external traders, not necessarily to punish anyone, but as a learning and evaluation tool."

At Boston-based Putnam Investments, Richard Block, head of global trading, utilizes TCA metrics for many things, including assessing broker quality. While Putnam's traders use the tools to analyze trading results the day after the trade is completed, Block scrutinizes the numbers on a monthly basis. "We do look at [TCA] as a guidepost," he says. "If there are firms where the cost numbers are significantly higher than forecasted costs or versus their peers, we need to drill down further. We look at broker costs in concert with other factors that drive trading strategies."

However, Block cautions against relying entirely on TCA models to rank brokers and route order flow. "The broker is not the one pulling the trigger on the trade, so we have to bear that in mind," he points out. "He is the third decision maker on a trade." There's a series of steps that occur before the broker receives the trade, Block explains. "Our portfolio manager selects what names to trade. Our [internal] trader selects strategy, pace and venue, and then selects a broker to handle the order under his direction," he says. "To just take the numbers as a metric and decide order flow and evaluate a broker based on that, I think, is a wrong decision."

In fact, Putnam takes many other factors into consideration. "The factors that drive our traders to select brokers basically haven't changed a whole lot," Block continues. "It's capital usage, it's market intelligence, it's order handling and responsiveness, and access to position traders."

However, other sources confirm that many buy-side traders indeed use only the pre-trade and post-trade statistical models to rank their brokers, which helps them determine how to direct their order flow. Peter Weiler, SVP of the Investment Manager Group at Abel Noser, suggests that this reliance on TCA arose out of necessity. In the late '80s and early '90s, there wasn't any type of grading system to measure broker performance, Weiler explains. "There were very few traders and brokers being scrutinized," he says. Now, according to Weiler, the industry has changed from "a pass/fail scenario to a report card scenario."

For example, at mutual fund complexes, which "have had onerous regulations thrust upon them," traders have taken ownership of the TCA tools, says Weiler. "It may verify some instinct that this particular broker is not performing well. And, on the compliance side, they will ask questions of head traders, and if there are numbers that are wild and woolly, they will ask for explanations," he says.

But are these metrics determining which brokers get the order flow? Or, does the buy-side relationship with the sell side still reign supreme? "Both play a role," says John Feng, a consultant with Greenwich Associates in Stamford, Conn. "As long as this is a business that has human beings involved, relationship will play a role," he says. But "execution quality is a key ingredient," he adds. When the research and consulting firm asked institutions how they evaluate the overall performance of the sell side, they mentioned execution quality, minimum market impact and anonymity. But they also mentioned a good relationship, adds Feng. "The two, in a sense, cannot be completely de-linked."

According to a Greenwich Research study conducted earlier this year, nine out of 10 institutions in the U.S. have a formal TCA process in place. "It varies a bit from investment managers to mutual funds to hedge funds, but the usage is pretty much spread across the board," notes Feng.

Robert Shapiro, SVP of Abel Noser's Advanced Strategies Trading Group, says, "TCA empowers the buy side to grade the sell side - at least when it comes to this execution dynamic - with a degree of granularity." A former head trader for Iridian Asset Management on the buy side, Shapiro uses advanced trading analytics and strategies at Abel Noser, an agency-only broker that provides TCA to pension sponsors and investment managers, to help buy-side firms optimize their trading styles.

"The more sophisticated buy-side desks have adopted a leave-no-basis-point-behind approach to trading. They use TCA as a tool to capture more alpha [or extra market returns] on a regular basis, and that leads to a logical extension on how they actually allocate trades," says Shapiro. "When used correctly," he continues, "TCA is highly objective. It is data that is simply crunched and analyzed in its purest form to determine execution quality."

Pulling Rank

According to Joe Gawronski, COO of Rosenblatt Securities, an institutional agency-only broker, the trend of using metrics to rate brokers began among quantitative asset managers, who historically did not use much, if any, Wall Street research, and consequently were able to use execution-only brokers that offered unbundled rates. "It's the quant shops that began rating their brokers because they could unbundle," he says. "For a long time, we've been ranked by our quantitative buy-side clients, usually quarterly rankings, sometimes monthly," Gawronski adds. Some clients "have a strict formula for how often you get ranked and your rank determines directly how much business you get," he says.

While rankings based on execution quality started with quants, "It's beginning to permeate the rest of the buy side," observes Gawronski. Now, traditional asset management shops and mutual funds have started to get involved in ranking their brokers, "not only to reward them for giving great research, but also to reward those that give great execution," he continues.

Meanwhile, buy-side traders say they are studying the data from post-trade analysis reports to spot trends and outliers - trades that fall outside the range of what's statistically expected for a given stock - but they note that brokers can look horrible in an isolated quarter, so they look at the results over time. "You can find trends in a quarter, but I don't think one quarter's performance makes or breaks a relationship," says Brian Williamson, VP at The Boston Company Asset Management (BCAM), who trades small cap stocks, a $300 million highly illiquid sector. Williamson says he has been monitoring TCA for about nine years. "It's a giant process," says the equity trader, noting that BCAM reviews its brokers and does extensive in-depth analysis with third-party services - including Abel Noser and ITG - on a pre- and post-trade basis.

Whereas buy-side traders used to rely on paper-based reports reviewing trades monthly and quarterly, the new, so-called real-time TCA tools are integrated into the trader's front end, Williamson notes. "Our management and senior traders want to know what is our real cost and how are we affecting alpha in the portfolio," he says. "Traders want to know how much alpha are we missing - are we missing 30 basis points because the transaction costs were 30 basis points?"

Like Putnam's Block, however, Williamson cautions against putting too much weight on TCA analysis when rating broker performance. Basing broker selection on TCA numbers may not be fair because most orders are not market orders; rather, they're limit orders, he contends, suggesting instructions given by the buy-side trader to the broker could influence the results. But there are other times when a broker has discretion to be more or less aggressive in handling the order and giving instructions to the floor, Williamson explains. As a result, "TCA can be a muddy water to look at," he says. "We like to look at this as a partnership with the broker - we check our performance together."

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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