Most advisers and wealth managers have placed listed investment trades at some stage in their career. Consequently, most are aware that trade execution can have a big impact on price, particularly when it comes to larger or illiquid orders. In fact, poor trade execution can mean the difference between strong investment performance and a poor outcome. This is why a whole section of the finance industry is dedicated purely to trade execution. In this note we explore this topic, why it is important, and what it can mean for investment returns.
When it comes to executing a listed trade the quickest and simplest way is to sell into the best bid, or buy the best offer, as quoted on the listed market. This is known as “crossing the spread”, however on the balance of averages it comes with an immediate cost (in addition to brokerage), being the price differential between the best bid and offer. For small orders in large liquid companies this cost is usually small. However the larger the order (or the more illiquid the stock) the more likely there won’t be enough volume to fill the entire order at the best quoted price on the other side. Meaning you must accept a poorer price as your trade moves through the quoted price levels.
Rise of the Geeks
Given large funds need to execute large orders this poses a problem, as their trades will inevitably impact the market. This is where the resident geeks at sell-side (broker) investment banks come to the fore. By creating “algorithms” that, in most cases, essentially drip feed the orders into the market over time, the overall impact can be greatly reduced. However it is a delicate balancing act…the longer it takes to drip feed the order, the more chance the stock has of moving away from the intended purchase/exit price. The optimal answer, therefore, involves complex math’s equations with a number of inputs, including the urgency of the order and the historical price behaviour of that particular stock.
Rise of the Flash Boys
Whenever you have clever people trying to outsmart a market, you will have people who are even more clever trying to outsmart them. This is where the “Flash Boys” come in. Also known as “high frequency traders” or “HFT”, these guys build algorithms that are designed to “game” the sell-side algorithms, essentially creating a geeks arms race. A simple example of a common HFT strategy is for them to work out when a broker algo is buying a large order, then purchase some of that stock ahead of that algo. They then sell it back to the algo at a more expensive price. All of this can take place within the blink of an eye. In fact these strategies can be so lucrative that in some cases HFT firms pay stock exchanges big bucks to have their computers “co-located” at the stock exchange office, so that the physical length of the cord between the HFT computer and the exchange is as small as possible, giving their computers a speed advantage. The sell-side brokers of course try to defend their algorithms against HFT, but sometimes with only limited success. Michael Lewis’s entertaining expose, “Flash Boys”¹, examined this side of the market and the lengths that some of these firms will go to obtain an advantage.
There are other options to help reduce market impact and the predatory actions of the Flash Boys, such as “block crossings” and “dark pools”, but these avenues come with their own pitfalls and would require a whole piece on their own to delve into.
Meaningful impact on returns
While the above makes for entertaining (if slightly nerdy) reading, understanding trade execution is important. Especially as it is up to the fund manager or investor to decide the best way to execute their order. While institutional sell-side brokers will provide the algorithms, each algorithm has its own distinct features. Not all algorithms are created equal and they all come with trade-offs. Having spent some of my career on the algorithmic trading desk of a large investment bank, this is something that I am acutely aware of.
Getting it wrong, particularly for larger fund managers, can have a big impact on returns. It must also be understood that some degree of market impact cannot be avoided, particularly for the larger funds. This is why hedge funds often close their doors to new money once they reach a certain size. When it comes to trade execution smaller funds are at an advantage, as being more nimble means being able to get in and out of holdings with minimal “slippage cost”. Something to keep in mind when selecting an investment manager.
Murrough O’Brien, former head of Electronic Trading at Citigroup and former board member of the Stockbroker and Financial Advisers Association and Chair of their Institutional Committee put it this way. “Sophisticated trade execution has become a vital part of today’s investment process… utilizing all of the tools that a trader has in their arsenal, from algorithms and transaction cost analysis to executing on different trading venues, truly differentiates funds with good performance from those with exceptional performance. Execution is also in the cross-hairs of regulators globally at the present time and with the emergence of MiFID II in Europe and RG97 in Australia. The need for funds to achieve “best execution” for their clients has never been more important.”
¹ Lewis, M, 2014, Flash Boys: A Wall Street Revolt, W. W. Norton & Company, US.