Execution performance is in the eye of the beholder

Transaction cost analysis is far from an exact science, but its value for buy-side traders looking to monitor and improve execution performance will be critical as more sophisticated tools emerge.
By None

In our poll this month we are asking how buy-side traders can improve their monitoring of execution performance.

A good place to start is with transaction cost analysis (TCA). Theoretically this provides buy-side firms with statistical feedback of their execution performance.

Typically the asset manager gathers data on trading activity such as the order ID, timestamps, broker and price of execution. This is put in a file and sent to a third-party TCA provider which then compares the firm's actual transaction costs to a model of expected costs, based on the firm's order sizes. The data is also measured against market data to compare the price of stock when an order arrives on the trading desk to when it is executed. Each trade is also modelled so that its characteristics can be mapped against common variables for trades made by other firms, to enable benchmarking. Together these measures, which may vary widely from firm to firm, are used to calculate the cost – and therefore quality – of a trade.

Then, when the worst performing trades are identified by the buy-side firm's preferred measures, an analysis can be initiated on how to improve performance.

This process is not perfect. The data in the analysis that is provided by the TCA vendor can only be as good as the data it is based on. The data is from a number of sources, each presenting a possible weak point. Data from trading venues is notoriously non-standard.

If a trader is having a busy day the order management system (OMS) may be updated late or in error, creating flaws in the data. Even when it is correct, the system may not record the granularity of data needed, for example the venue where a trade occurs.

If an algorithm is used, a buy-side firm may not necessarily record which algo was used. That makes analysis a challenge as it must clearly measure the outcome against the intended strategy.

The market data set selected by the TCA provider may not match the buy-side firm's view of its market, the liquidity it can access, or whether off-exchange data should be included. By comparison in-house TCA systems can be tailored for specific performance measurement, but are expensive and time-consuming to run.

When put together well, using a strong benchmark that is visible to the fund manager the results can be invaluable and contribute to the broader investment process.

Further performance improvement could be realised by monitoring performance as it occurs. But firms that rely on an OMS face impediments as these platforms typically act as databases, populated with data post-event.

Some brokers are offering real-time TCA services already, on the basis that trades are routed through them.

If that doesn't appeal – not least because such broker-provided services cannot be used to provide a consistent picture across all orders – the rise of execution management systems (EMS) which operate on a real-time basis could provide the impetus for change. By either implementing new software that connects to an EMS or using an EMS with integrated reporting functionality, buy-side firms can develop an enhanced level of performance monitoring.

By tracking the performance of a trade across a day, the investment institution can alter its execution if the fills move outside of performance parameters, for example speeding the process up if a price begins to move away from the trader. This can only be achieved if the trader is presented with data in real time and in a manner in which it could be interpreted and acted upon.

Increasingly the value of TCA is being realised at a higher level within the buy-side community. Execution costs may never have the same billing as headline returns, but they receive more attention in uncertain times. As a result, forward-looking firms are constantly seeking to improve execution. Investment in the tools that enable accurate monitoring of execution and interpretation of results is therefore crucial.

Click here to vote in this month's poll