Related Sidebar: TCA by the Numbers
Transaction cost analysis (TCA) means many different things to different firms. Whether it's used on a minimum level to measure best execution for compliance reasons, applied across the entire life cycle of a trade or leveraged to help determine trader compensation, every firm is unique in the way it uses or relies on TCA.
Which,
of course, doesn't make it easy to get to the bottom of what exactly
the "next generation" of TCA might look like and how the buy side will
continue to incorporate TCA into the trade process.
Bill Stephenson, SVP and head of global trading strategy at Franklin Templeton Investments, however, believes he may have found the future of TCA. Stephenson uses a new TCA benchmark that he hopes might one day become an industry standard. With more than $600 billion in assets under management, Franklin Templeton is actively working to implement a next-generation TCA strategy based on a "value add" benchmark that, Stephenson says, is efficiently helping his firm quantify trader alpha.
"We have a highly structured execution process and a strategy that can be customized to different portfolio needs," explains Stephenson. "It's the goal of the trader to capture or preserve short-term alpha."
He adds that traders ultimately accomplish this by balancing the need for liquidity with price risk. "We view liquidity as one of our toughest challenges but also one of our biggest opportunities," Stephenson says.
But gauging whether a trader is balancing these two tricky sides of a trade while still aligning with the firm's investment process is something with which Stephenson traditionally had grappled. In particular, he says, he wanted a way to evaluate the performance of the firm's large orders, which generally take days or even weeks to complete.
Years ago, Stephenson relates, he had worked with Franklin Templeton's TCA provider, State Street, to build an in-house global TCA system, but eventually figured out he wanted a Web-based system so he could log on and download reports directly. Previously, he had been receiving very large e-mail files each day with the data-heavy reports, which was cumbersome. "We have trading desks around the world, and it's much easier to log in and pull the data down," he says.
In early 2004 Stephenson made the switch to ITG as his TCA provider, and they worked together to build on Franklin Templeton's existing "value added" benchmark, which Stephenson calls a multiday VWAP variant-type of benchmark. Stephenson notes that he also had been using ITG's Average Cost Estimator (ACE) for forecasting trade costs. But while it was good for smaller size trades, he contends, ACE didn't work as well for large trades. "The goal was to have a target percentage of volume over the life of the order, and to measure the trader's discretion around that benchmark," says Stephenson.
Accoding to Stephenson, ITG then came to him with a new benchmark they had termed "Participation Weighted Price," or PWP, which was similar to what Franklin Templeton had been using but with less-complex calculations. In addiiton, ITG could standardize it for other clients, as well.
"It is based on a target participation rate over the life of the order, so if it was 10 percent participation on a 10k share order, our price would be measured against the VWAP of the next 100k shares that trade in the market," explains Stephenson. "Once 100k shares trade, the benchmark is static. This may take 30 minutes or two days, ... and we may execute a 30-minute order over three minutes or three hours. PWP will calculate the trader's value added to that trade based upon this achievable price given the benchmark strategy."
The PWP benchmark also is customizable, Stephenson points out. "Different portfolio managers have different participation targets -- some might be aggressive, some might not -- so it can be customized," he says.
Stephenson adds that balancing the short-term alpha capture versus the longer-term investment strategy is always important. "PWP is not the be all and end all, but generally, over time, it aligns with our overall investment strategy," he comments.
"We believe best execution is a predictable execution," Stephenson continues. "In other words, our process is structured, we can identify and manage our risks, and we can deliver results within an expected cost range in any market under most market situations. Managing trading costs, positions and trader risks around benchmark deviations is part of our process on a daily basis."
Adam Sussman, research director at TABB Group, says other buy-side firms also are moving more toward TCA for measuring trader alpha. "They are looking at the implicit costs incurred during these trades, and they're looking over a period of time," he says. "They're also comparing the types of discretion a trader may be given -- timing, price, is the portfoio manager putting soft limits on the order, etc."
Sussman adds that by looking at TCA over a period of time and measuring "trader alpha," firms then can look for trends and better see porcess changes that might be necessary to improve overall performance. Ultimately, effectively leveraging TCA in this way leads to a more holistic approach to the investment decision and trading process, according to Sussman.
"Firms need to look at it as a more fluid process -- from the timing, to the pricing and urgency, and then how that is commuicated down to the trader," he says. "All of these things need to be taken into account."
Sussman adds that most larger shops are making strides in this area, leveraging TCA to improve their entire investment process. "Everyone agrees that if you're a firm of a particular size, you need to make the process more fluid, and there needs to be a feedback loop among the portfolio managers and traders," he says, adding that a lot of firms already have begun making progress in this area.Effective TCA Requires Behavioral Changes
But measuring trader alpha and effectively using TCA on a daily basis can only be achieved with a behavioral change on the trading desk and beyond, contends Jason Lenzo, head of trading at Russell Investments. According to Lenzo, TCA becomes an effective tool when it is part of the overall process and involves more communication and interaction at all levels of the trading process.
"TCA should be understood as an opportunity to optimize the behavior
with which traders are interacting with the market," says Lenzo. "There
has to be a shift of consciousness to viewing TCA as a tool because
there are too many who view TCA as just another report that has to be
filled out every month. It can achieve so much more."
While most traders don't necessarily have a lot of input into the investment process, TCA is a way for them to measure results and ultimately learn how they can do their jobs better, Lenzo adds. "That's the trader's goal -- the ability to discover price and liquidity within the context of the goals of the clients -- and there needs to be a way to delineate that quantitatively," he says.
Lenzo compares the state of TCA today to where algorithmic trading was a few years ago when it first hit the scene and traders saw it as antagonistic. "It wasn't clear to traders at the time that those were great tools to help them do their jobs better. But I challenge you to find a trader today that doesn't use some type of server-based execution," says Lenzo. "TCA acceptance will follow in a similar fashion as people understand that if its properly deployed, it's a great help in the measurement of how you're doing."
The two main changes Lenzo foresees for the next generation of TCA are broader acceptance and usage on a real-time basis, as well as more forward-looking TCA -- "TCA not based on historical norms and market averages but based more on current market conditions," he explains. "Measuring results in real time as you're trading and making adjustments and changes accordingly."
But getting buy-in to the behavioral change and the use of TCA in real time as a tool to see where traders are adding value first means selling people on the idea that it's worthwhile. Unfortunatley, "People view this as something that is combative and not done in a collaborative manner -- you're grading someone," says Lenzo.
What's Next for TCA?
According to Clarke Roberts, director in the portfolio and automated trading group at Merrill Lynch, the use of TCA for intra-day tactical analysis -- a less disruptive but equally transformative application of TCA compared to measuring trader performace -- will be a hot area. He describes a scenario in which firms use TCA to adjust to market conditions and overall performance throughout the day and change a strategy on the fly. But, Roberts adds, he also expects the longer-term TCA applications to be utilized more and more.
Beyond that, Roberts sees the next generation of TCA used on a global scale and even across asset classes. "The next step is incorporating all desks -- cash trading, portfolio trading, equity derivatives and other asset classes -- into not only regional but also global TCA reports," he predicts.
TABB Group's Sussman agrees. "The data is becoming more widely available on a global basis and technology is being deployed across asset classes and geographies," he comments. "This combination of data and technology for trade capture is the foundation necessary for TCA beyond U.S. cash equities."
According to Scott Burrill, partner and managing director, global head of consulting and analytics, at Rosenblatt Securities, incorporating TCA as a core part of the investment process is a key to the buy side's success going forward. "From an institutional perspective, I see TCA moving upstream, feeding through the life cycle of the investment idea," he says. "It is of even greater importance now as the markets have become so fragmented and there are so many disparate ways to execute trades. You have to understand what the underlying costs of participation in these venues are."
The prospect of more closely linking the portfolio manager and the trader via TCA tools also is something that Burrill points to as driving buy-side adoption of TCA. "Often times the portfolio manager and the trader have cross purposes -- the PM wants the stock to go up, and when the stock begins to move, a trader wants to wait for it to go down," he explains. "They need to get talking, to bridge the gaps. Linking the portfolio manager and the trader is very helpful."
Ian Domowitz, managing director of ITG's analytical products and research group, says that the next big thing in TCA isn't actually anything new, but rather "proper use of the concept." According to Domowitz, this means spanning the life cycle of the trade and providing analysis at every step of the way.
"Transaction cost analysis is not something you do only at the end of the day or quarter. Measuring, reporting and analysis are an essential part of the trade process, and the results of the analysis must be incorporated at various stages of the investment process," says Domowitz. "Where does TCA enter at the portfolio construction phase with respect to the generation and evaluation of the strategies at the pre-trade stage? Where does it enter during the execution process? Then given all of that, how do we measure and improve that?"
As for future TCA benchmarks and ITG's PWP offering, Domowitz says, clients are leaning toward customization. "There are roughly 32 benchmarks available for any user of TCA, and more than 100 done specifically for individual clients," says Domowitz. "PWP was driven by client discussions and has a variable time horizon, which is appealing, and it's very flexible -- users can adjust the participation rate to different sensitivities."
Still, Hugues Deroubaix, director of client connectivity at GL Trade,
hopes to see industry consensus around benchmarks in the future.
"Something will emerge out of the crowd to be considered a standard
benchmark, because if we don't have that, we can't really evaluate
trader performance," he says.
TCA By the Numbers
A report earlier this year from TABB Group, "Imperfect Knowledge: International Perspectives on Transaction Cost Analysis," predicts that the use of equity post-trade TCA among U.S. and European firms will climb to 90 percent by 2009, with 38 percent of those firms looking at TCA on a daily basis.
The study also found that almost two-thirds of U.S. and European equity firms currently spend more than $100,000 a year on TCA. And TCA already is moving beyond equities, with 58 percent of U.S. buy-side foreign exchange traders working to measure execution quality and transaction cost. In addition, 25 percent of equity options traders report using internal models to accomplish this.
When it comes to using TCA to measure and compensate traders, the study found that nearly 75 percent of firms do evaluate traders against TCA, but only 25 percent believe TCA should be used as part of trader compensation. For firms that are using TCA as part of trader compensation, they report that up to 20 percent of bonuses are based on TCA.