Handicaps and Handcuffs

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Building Better Perf ortndlrceCOMMENTARY 75 APRIL 2OO3

grorrltHANDICAPS AND HANDCUFFS

Among the thousands of numbers calculated in a typical Plexus report, the one that usuallydeserves the most attention is the "value added" by the trade desk (trading costs minusPAEG/L) This number indicates whether a firm's trading is more or less'efficient than tradingby other firms with similar orders.But not all trade desks play on a level playing field. Every trading desk is unique in its ownway. Some firms have a relatively straight-forward process wheie managers decide whichstocks to buy and sell, then enter the orders into their OMS, giving the traders full discretionto trade. But in most cases, traders face limitations and instructions that significantlycomplicate their job, and iikely increase trading costs.In this commentary, we evaluate the various handicaps and handcuffs that traders face andtheir likely impact on value added. Specifically, we discuss, quantify, and elaborate on priorresearch regarding how directed commissions, soft dollars, cash matched (or pairs) trailing,firm location & order times, and firm size affect the trade desk's abilitv to bbat their PAEGILbenchmark.We then pre_sent our findings on how manager limits affect the desk's ability to achieve bestexecution. Each of these barriers has a cost; once recognized, it is up- to each firm tocarefully weigh the costs versus the expected benefits, communicate their'findings internallyand with their clients where appropriate, and adjust their process accordingly.

A "Handicap" is defined by Merriam-Webster as "adisadvantage that makes achievement unusuallydifficult." From another perspective, in the gameof golf, the probability is that a player with a lowhandicap is going to shoot lower scores than aplayer with a high handicap. Likewise, ininstitutional trading we can also count on thelikelihocd that a trading desk encurnbered bytrading restrictions is likely to have higher relativecosts than trading desks that don't.In an attempt to put trading desks on an evenplaying field, we identify and quantify the primarytrading differences that handicap trading desks.First we summarize prior research (by Plexus, aswell as independent academics using PlexusClient data) where trading disadvantages hdvebeen documented, and then we presentadditional findings and theory about other tradingrestrictions.

We know from securities analysis that eveoption has a value that can be estimated. Finstance, equity option valuations canestimated with the Black-Scholes modSimilarly, we would suggest that to a tradoptions to trade have value. For instance, toption to trade with any broker should have valover the instruction to traCe with only brcker XYLikewise, the choice of when to trade (rather thbeing forced to trade immediately or to washould in theory have some value.The cost of a trading restriction can be viewedequal to the value of the lost option of talternatives. So by determining the differenbetween an unencumbered trading desk andhandicapped or handcuffed trade desk, we cplace a value on the restrictions. The value otrading restriction reflects the tradeoffs of timpotentially adverse price moves (volatility), athe resulting returns.


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first trading handicap we review is "Directed"whereby a client instructs a manager toin iheir account to a specific brokercommissions in the process)' Rathertheir regular venues or brokers' themust use the specified broker' Theproblem is that those brokers may not beto access the liquidity available to otherFor some types of trades (like plain

or value-oriented trades) there may be littletrades) the cost may be

Thus far, Plexus has documented theof Directed trading twice, most recently inCommentary 57, "Directed Brokerage: NoLunch - Revisited"' In that study'we found

on a PAEG/L adjusted basis, Directed tradesNon-Directed trades by -26 bps' Plus' thelrJcted trades had weaker returns than the Non-Directed trades by an average of 33 bps'

Cash Matched & Pairs TradingAs documented in our Commentary 71' "What DoThe Good Desks Do?", we found that cashmatching and pairs trading tends to disadvantage Ythe tradl desk. Generally, cash matched firmsmust complete their sells in order to generate the-fasfr to pay for the buys' Therefore the option ofbuying immediately may have been eliminateduni tf'" sells may have added pressure to gettraded quickly .o ih" buys could be initiated' Thevalue lost by cash matched trades was -30 bps'Pairs trading is particularly expensive becausespecific tradLs must coincide with each other'Usuatty, when it's a good time to buy' it's a lousytime to sell and vice versa' But you don't usuallysave enougi-r on one io compensaie for ihe extracost on thL other. A good analogy is in long

distance running; you don't make up enough timeon the downhill to compensate for lost time on theuphill.Firm Location and Order Timesln our Commentary 69, "Time Of Day Effects OnSoff Dollars Trading Costs,,, we discussed order times and their

with soft dorar rerationships, traders use specific Sjrect Jn trading costs and varue added' The theorybrokers in order to generate commissions to is inat orders praceo after the open can place thesatisfy the firm,s soft doilar obrigations. nguin, il ir traders at a drsadvantage because a significantis a case when rather than using the broker of percentage of trading occurs at or near the open' ltchoice, the trader uses one or more rp"riti"J r"tt becomes more difficult to camouflage an illiquiddorar brokers. The cost again is the rost option of order when trading is initiated after the open'using other brokers oi trading ;;#r. In Absorute trading costs for orders after the open,,rnstitutionar rrading and soft Doilars" conrad, *"r" ror" than 30 bps higher than pre-open orderJohnson,andWaha|documented(usingcosts'u:::,:|T'"'',afteropenordersWeredisguiseo plexus client data) economicaliy roughiy 'lu bps more expenslve than pre-openmeaningful costs from using soft doilar brokers' orders'of course, the costs are offset by the benefits of Foilowing up on that research when we look at justthe soft-dorar brokerage (whether in the form of crients hLadquartered in Pacific standard Timeresearch, commission recapture, or third party cities we find that: [1] the west coast firms werereimbursement). stiil, the authors estimated that more rikery to have a smaller than averagethe incrementar costs exceeded the benefit (with percentage of orders praced prior to the open (17%a **%reimbursement rate). consistent with ou.. versus [a% to, the full sample) and [2] the gaptheory, we can estimate an overa, cost to soft versus 'AEG/L on pre- and pOSt-Open orders wasdorar brokerage in the form of "ii*."ii"g il.," rarger than in the full sample' In other words' it mayoption of using better brokers. 'ih; -;;;r";" nelmportant for west coast Portfolio Managers toincrementar cost in the study was -29 np, i"inrvs be earry risers given the apparent location

and_24bps for sers. disadvantage (at reist from the trade perspective)'


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Firm Size ($ Turnover)Also included in our Commentary 71, was adiscussion of size in terms of dollars traded perquarter. Firms trading under $4.5 billion perquarter had Value Added by the trade desk 7 bpsbetter than firms trading more than $4.5 billion perquarter. Additionally, the top ten largest firms wereanother 4 bps weaker versus PAEG/L than thesample of large (high turnover) firms, or '11 bpsweaker than the small firms.The theory explaining this relationship is thatlarge firms have greater liquidity demands andtherefore sometimes orefer to complete tradessooner when a contra is identified, while smallerfirms may be more cost conscious and maychoose to wait. In other words, when liquidity isavailable, the larger firms often waive their optionto trade at a later time even if the cost is higherthan they expect. The evidence shows that largefirms tend to have lower value added whenproviding liquidity. Large firms seem to forgoconcessions to capture liquidity.Limits

Many firms allow their managers to include eitherexplicit or "soft" price limits with their orders. Softlimits are rarely documented and therefore difficultto identify and measure, but we currently measureactual hard limits (recorded in the OMS) for '15domestic money manager clients. There are othertypes of order instructions that some of our clientsuse and they may be topics of future research(i.e., oh of volume limits, share limits, temporaryholds, and cancels).Some firms use limits differently, giving rise tosome variation in comparability. For instance,some managers place hard limits and don't

change them, thus incurring opportunity costrather than high trading costs when the stocprices move away. Other managers will changthe limits after the stocks have moved awayleading to higher time delay costs. With limits, itshort-sighted to focus solely on value added sincthe adverse effects often manifest in other area(weak returns and/or opportunity costs). Yet, wcan make some conclusions and generalizationabout the results we see for limits.The sample of clients using limits is a diversifiegroup including both large and small camanagers. On average, the limits accounted fo8.5% of the firms'dollars traded. Several had 15or more of their order flow saddled with limitswhile othei's had limits reoresentinc 1o,/" of thedollars traded.Overall, limits generally occur on orders witstronger returns than non-limit orders. Of coursethe main objective of placing a limit is to prevenhigh costs and consistent with that, the majorityfirms using limits had lower trading costs versuPAEG/L on the limit orders. But the primary findinis that B of the 15 had drarnatically higheopportunity costs on their lirnit orders leading tweaker portfolio returns than they would have hawithout using limits. The remaining 7 had similapotential returns for traded and unexecutereturns resulting in less damaging results.In terms of overall conclusions, the results witlimits are not completely cut and dry. We found tolittle evidence to recommend changes to onthree of the iifteen iirms. t'et with over haif of thfirms, we did see evidence that the limits wercounterproductive. Either the firm ended umissing out on good trades, or the temporarlimits were eventually lifted or changed and thetrading costs were higher in the end.

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Trading Handicap SummaryTrading Handicap Expected Additional Gost BenefitPairs TradingCash Matching -30 bps Compatible with quantitative strategiesMay be conducive to basket/programtradesSoft Dollars -29 bps on buys-24 bos on sells Soft dollars payments for research and/orother servicesDirection -26 bps Client recaptures some commissionsAfter Open Orders 10 bps Additional pricing information available.PMs can sleep laterDesk Size (Higher turnover) -7 to -11 bps More assets usually equals more profitfor firmPrice Limits & Cancels Opportunity costs Limited tradino costsShort Sale Higher trading cost Creates market neutral and downsideprotection options

Although most discussions of trading efficiencyfocus on a firm's trade costs versus PAEG/L, thepreceding information can be used to justifyhigher than PAEGiL costs for trading desksbridled with trading handicaps. Of course, the flipside is that firms with little or no trading handicapsshould be expected to beat PAEGiL since thePlexus Universe includes firms that have theserestrictions.What we recommend for clients that use limits(and/or the handicaps listed above), is to askPiexus to analyze their returns and costs(including opportunity) to determine the explicitand inrplicit cosis. iv'iarragers using iirnits need ioknow when their instructions are counter-productive to their own (and their clients)performance.With each of the conditions we've listed, there is arationale for their existence and a desired benefit.That benefit needs to be carefully weighedagainst the cost to determine whether the tradeoffis worthwhile. Direction, soft dollars, cashmatching, limits, etc., are usually beyond anycontrol of the trade desk, but the costs still shouldto be communicated to the appropriate decisionmakers.

We haven't conclusively proven our theory thathandicaps and handcuffs placed on traders havea cost that is equal to the value of the eliminatedtrading option, but certainly the research to dateshows a clear pattern of generally consistenthandicapping costs (-10 to -30 bps). Our belief isthat there really is value in allowing traders fulldiscretion in terms of both choosing the liquiditysources and the timing of each individual trade.Only when the traders control both of thesefactors can the trader's skill be fullv utilized."Revisiting Directed Brokerage: Still No Free Lunch", Plexus Group,December 1 998. (http://www.plexusgroup.com/commentaries/COMM-57.odflJ. Conrad, K. Johnson, and S. Wahal, "lnstitutional Trading and SoftDollars", Journal of Finance, February 2001.

( http : //www. b u s. e m o ry, ed u/swa h a l/3 97-4 1 6. pdfl"What Do The Good Desks Do?" Plexus Group. Julv 2002(http://www.plexusgroup.com/commentaries/commentary71 . pdf)"Time Of Day Effects On Trading Costs", Plexus Group, January 2002.(http://www.plexusgroup.com/commentaries/commentary69. pdf)

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Handicaps and Handcuffs