Published On: Mon, Oct 1st, 2012

How Do You Measure Trade Performance?

Josephine Kim, Director, Asia Pacific Execution Sales, Bank of America Merrill Lynch

Josephine Kim, Director, Asia Pacific Execution Sales, Bank of America Merrill Lynch


Measuring trade performance: The path to your best trading strategy

The topic of best execution is increasingly coming under the spotlight. In a bull market, people tend to focus on how much money they can make – but in a tougher market, the emphasis is on how much they can save. Where trading is concerned, this means that people are now paying more attention to how they can best control their costs.

The results of the trade performance poll indicate that 41.38% of respondents are measuring trade performance using volume weighted average price (VWAP) as their benchmark. This is very much in line with what we are seeing – our recent figures show 40% of our platinum (top 25) clients are doing the same.

VWAP continues to be the favoured benchmark for a couple of reasons. For one, portfolio managers still tend to dictate which kind of benchmark needs to be achieved when they are directing orders to traders. When seeking best execution, they frequently focus on the VWAP price because most people think getting the average price of the stock is a fair measure – and also, in part, because most portfolio managers still focus more on picking the right stock than on the execution itself.

The poll found that arrival price was the second most favoured technique, with a score of 24.14%. Again, the popularity of this benchmark came as little surprise, although our figures are rather higher: 40% of our platinum clients use the arrival price benchmark. Traders tend to favour arrival price because it demonstrates clearly where they add value. The growing popularity of this benchmark is being driven by the fact that head traders are being given more discretion when it comes to making decisions about the trading timings and trading techniques.

High volatility levels in the market are also driving the move from VWAP to arrival price. Whereas a 21 day average used to provide an accurate reflection of the market average three or four years ago, this is no longer the case: the market reacts completely differently every day depending on the type of news being reported.

This market is evolving rapidly and if the same poll were carried out in a year’s time we would expect to see VWAP declining to around 30% and a corresponding increase in arrival price. At the same time, another interesting benchmark currently emerging is participation weighted price (PWP). Bigger institutions have started looking at PWP in the last year and in 12 months’ time we would expect to see PWP featuring in the poll results.

WHY MEASURE TRADE PERFORMANCE?
Interestingly, 13.79% of those polled said they measure trade performance only if they lose money. This tells us that there are some people who don’t look at trade performance as long as the market is good. In many cases this may be because they are focusing on how the stock itself is performing, rather than looking at the execution cost. Even some portfolio managers believe that choosing the right stock is more important than looking at the execution cost.

Furthermore, as the fourth option shows, 10.34% of people don’t measure trade performance at all. Some people simply don’t see the benefit of measuring trade performance, while some don’t have the resources to do so. We expect the number of people not measuring performance to drop over the coming year, however: as third party vendors like Bloomberg and TradingScreen increasingly develop their own execution reports, the buy side will no longer have to rely on brokers for these reports.

Most interesting of the poll’s findings is that 10.34% of people are only trading with the lowest broker fee. This is significant because the explicit cost, which includes the broker fee, only represents about 25% of the total execution cost – the remainder is an implicit cost relating to the market impact and whether the right stock is being traded at the right time.

The biggest saving that clients can make on broker fees is around five basis points, based on the gap between the cheapest and most expensive broker. Clients who only focus on commission rates are ignoring 75% of the total execution cost – and in Asia Pacific, where the average spread between bid and ask price is around 20 basis points, it is sometimes possible to save half this spread by going through the best execution broker or venue. People who focus only on commission rates are therefore ignoring significant possible savings here, and this is an area that the buy side needs to look at more closely.

TCA ANALYSIS
Analysing performance is a key part of ensuring that the right trading strategy is in place, and our research indicates that around 60% of our platinum clients are using transaction cost analysis (TCA) reports to help them achieve this.

A TCA report enables clients to assess their performance by looking at live trading examples and considering what results a different strategy would have achieved. In most cases, poor performance is caused by a gap between the client’s understanding of the algo behaviour and how the algo behaves in reality. A TCA report can show what the result would have been in a particular situation if a different algo had been used, ultimately helping clients choose the most suitable strategy.

Given the focus on managing costs, the BofA Merrill Lynch team is working in partnership with clients to help achieve the best execution and their business goal. Analyzing and scrutinizing performance is at the forefront of assessing trading strategies.

How the industry voted
Results:
How Do You Measure Trade Performance?

How Do You Measure Trade Performance?

Analysis
Measuring trade quality and performance in Asia has been growing steadily as new services, algorithm use rises and bearish equity markets have left the buy-side examining the entire investment vertical more critically than ever. The notion that the cost of trading is merely commissions, exchange fees and stamp duty still exists here, however, with 1/3 of opinion poll respondents not too interested or not aware of their total cost of trading. Those that did vote VWAP (volume weighted average price) was chosen 41% of the time as their method of measuring trade performance. VWAP is a commonly used benchmark in Asia for a number of reasons. First of all, it is widely available as a standard algorithm amongst the broker community. Additionally, amongst the buy-side there is also a belief that VWAP is the market average and is a low risk way of trading. It is also easily understood lending to over use when other algorithms such as a hidden algo types or implementation shortfall types could yield a better price. That brings us to arrival price. Here, almost 25% of voters were using this as their benchmark which was higher than we expected. It is encouraging to see that Asia is adopting this yardstick rather than VWAP more and more.

It was interest that almost 14% of voters only used trade performance benchmarks when they lost money. Ironically, by not always measuring and comparing trade performance these voters are quite possibly losing money on every trade and not exactly observing the Prudent Man Rule. As most know, securities in Asia are generally illiquid, carry wide spreads and can be volatile. Volume profiles show more liquidity during the first 30 minutes of the open and last 30 minutes before the close of the session suggesting tighter spreads and a greater likelihood of getting a better price when trading during these times. Spend some time with your low touch brokers and see what they have to say about which algos would make more sense given the market condition and the stocks trading behavior. That is what they are there for and you are likely to save more on the trade than you pay in commission by using the correct algo. The same could be said of the 10% who voted for only using the broker with the lowest price. You have to include market impact costs and very likely they are not using the lowest cost broker when this is accounted for.
Asia still needs some education in this regard. Go gettem sell side.

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