Buy-side traders’ execution decisions are arguably under greater scrutiny than ever, with clients expecting every penny spent on investment strategy implementation to be justified. This places great importance on the ability of global asset management firms to identify and manage a suitable benchmark for their trade execution performance across multiple countries and indeed portfolio managers.
While some have developed their own internal proprietary transaction cost analysis (TCA) system to help provide the type of performance data and reporting they require, the complexities and costs around doing so are often prohibitive.
Many buy-side firms use a variety of benchmarks to reflect the fact that objectives inevitably differ across trades. If minimising information leakage is a priority, for example, a VWAP benchmark may be used. Whereas TCA providers used to specialise in particular benchmarks, their services have evolved to measure execution performance regardless of benchmark.
Madison Gulley, director of global equity trading, Franklin Templeton, which trades in around 65 countries globally, says his firm has worked with its third-party TCA providers over the years to establish benchmarking and analysis methods to meet its particular needs.
“We were using Plexus, among other TCA vendors, around 1998, but wanted something that was more timely, fitted with our specific strategy and represented the percentage of volume of a particular order at a given time,” said Gulley.
To do this, Franklin Templeton created a ‘value-add’ benchmark that took into account targeted volume and average price over the life of an order as opposed to across the trading day. This means that even if a trade was completed more quickly, relative to the benchmark, trader performance would be measured only on the lifespan of that order. To begin with, this was done using Templeton’s own data and internal analysis, before ITG presented them with a new option.
“We felt our own benchmark was more representative than the Plexus benchmark we used previously, and we continued to evolve this over time,” says Gulley. “We did this for a few years before ITG came in with a web-based product that would manage this data and back-end analysis, while still allowing us to have our own proprietary benchmark that was flexible.”
ITG bought Plexus, a TCA and research provider, from J.P. Morgan in 2005. Now, Franklin Templeton still has a benchmark suited to its strategy and which holds traders accountable for their executions. The benchmark is calculated according to potential market impact and the cost of opportunity, and is adjustable depending on the characteristics of the trade, allowing the firm to measure how aggressive and passive strategies impact these two factors.
Gulley says that the benchmark enables Templeton to better align execution performance with the interests of fund managers.
“Larger institutions have mangers with different interests, so it may not be possible to use the same benchmark for every manager,” he says. “A manager looking for short-term alpha will be looking for opportunity rather than impact, where as a manager unsure of market events over the next week, for example, may be more concerned with impact.”
For those considering an in-house system, Gulley advises a thorough examination of the cost benefits. Although he admits that proprietary systems allow flexibility and customisation, the amount of resource and expenditure required to clean data from orders that may last the course of weeks, with multiple limits from multiple fund managers, would make this extremely difficult for buy-side firms to manage, especially if trading across a large number of stocks and/or markets.
While acknowledging that today there are still some issues relating to the reporting and timing of data, Gulley notes that continually working with an external provider has allowed Franklin Templeton’s TCA process to continually evolve in much the same way as if it had its own proprietary system.
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