Executives at some big public pension funds finally are beginning to focus on their managers' costs of trading stocks.
Certainly, a few public funds - such as the California Public Employees' Retirement System - have been measuring their costs of buying and selling stocks for years. And many corporate pension funds have been evaluating manager trades since the Labor Department clarified in 1986 that federal pension law requires investment advisers to ensure they receive best execution.
Among the public funds that more recently began to scrutinize trading costs:
The $11 billion State of Connecticut Trust Funds, Hartford, last year began asking its custodian, Mellon Bank, to regularly report its managers' execution costs, said Guy Garcia, principal investment officer of operations and trading.
The $37 billion Florida State Board of Administration, Tallahassee, began measuring trading costs of its in-house and outside managers nine months ago, said Steven Cusimano, portfolio manager. The fund, which uses outside advisers to manage about half of its assets, uses a system modeled after the methodology used by the New York discount brokerage firm of Abel/Noser Corp., Mr. Cusimano said.
The $50 billion New York City Retirement Systems conducts an in-house analysis of its managers' trading costs, said Jon Lukomnik, deputy comptroller for pensions. Donna Anderson, head of the division of investment strategy, did not return telephone calls seeking details.
Wayne H. Wagner, partner at Plexus Group, Santa Monica, Calif., suggests public pension funds are more interested in measuring trading costs than corporate pension funds because many corporate plans are already well funded, while public pension funds need to watch every penny.
Securities trading costs consist of two elements - brokerage commissions and market impact, or the spread between the price at which a stock just traded and the price at which it was bought or sold.
The smallest price interval at which stocks trade is usually one-eighth, or 12.5 cents, while commissions range between 2 cents and 6 cents per share. As a result, public pension fund executives are discovering they can save millions of dollars more a year by focusing on market impact costs rather than brokerage commissions.
But, there is little agreement among pension executives, money managers and the consultants who measure market impact on the best method of measuring it, or what benchmarks to use.
The problem is the trading cost measurement system many public pension funds use - offered by Abel/Noser - is widely considered to be flawed and might not provide a true picture of market impact costs, experts say.
The system examines the price at which an institution buys or sells a particular stock against the volume-weighted average price -total dollars traded divided by the number of shares traded - of any given stock over the course of a day. Plan sponsors admit the system can be easily gamed so their money managers' trades look good against that benchmark, yet they continue to use it because they get the service free as long as their investment advisers do sufficient trades through Abel/Noser.
Said Theodore R. Aronson, partner at Aronson + Fogler: "I could give you 500 instances where beating the average-weighted trading cost would still give me a lousy price," such as in a falling market.
(His Philadelphia quantitative money management firm is one of the few to voluntarily provide clients with a breakdown of brokerage trading costs every quarter.)
Gil Beebower is executive vice president at SEI Corp., New York, which offers an alternative trading cost measurement system. He contends Abel Noser started giving away its reports to plan sponsors to put pressure on money managers.
But Stanley S. Abel, Abel/Noser chairman, justifies his firm's practice. Not only does his firm charge clients paper-thin brokerage commissions of 2 cents per share, he says, but it also assures them it is obtaining best execution by measuring it. "We are not only measuring our result but everyone else's," he says.
What's more, Mr. Abel says his firm is not wedded to using the volume-weighted average pricing model and can measure trading costs for pension plans using whichever methodology they prefer.
Pension executives admit no system is perfect, but they say Abel/Noser analysis gives them the best value for their money - because they don't have to pay for it.
"With a small number of trades, it is a system that is gameable. I accept that," says Russell L. Olson, director of pension investments at Eastman Kodak Co., Rochester, N.Y., which has been measuring its trading costs this way for several years.
"But with 90 million shares traded (by Kodak's pension fund last year) and upwards of a dozen managers, this is not a factor in my judgment," he said.
Based on Abel/Noser's tracking system, Kodak last year incurred average trading costs - including brokerage commissions - of 4.6 cents per share, or 3.4 cents per share for commissions and 1.1 cents per share for market impact. That's for stocks traded on the New York Stock Exchange and over the counter, Mr. Olson said.
Kodak does not pay for Abel/Noser's trading costs system because its money managers do enough business through the brokerage, Mr. Olson confirmed.
The photography and chemicals giant looked at SEI's system, but "felt for the cost of doing it, the incremental value would not be worth it," Mr. Olson said.
Florida's Mr. Cusimano also acknowledges the trading costs methodology his fund uses has shortcomings, but is still useful.
"I imagine it will be at least a couple of years before we feel we have enough data to determine who the consistent performers are," he says.
Meanwhile, the California employees' fund, which has $27 billion in equities, uses Abel/Noser's system for measuring the cost of domestic trades, and Plexus Group's system for measuring costs of foreign trades by outside managers.
Based on the report from Abel/Noser, the Sacramento-based fund found it incurred trading costs of 4.3 cents per share in the second quarter of 1994. Of that, 3.7 cents was in commissions and 0.6 cents in market impact. The total: $3.35 million to trade 78 million shares valued at $2.7 billion, said Carl Wilberg, principal investment officer.
The California fund uses the trading cost analysis to monitor its managers' performance. Staffers have found instances, Mr. Wilberg says, "where they had lousy transaction costs, yet because of stock selection or timing, they had outperformed the benchmark."
Then there's the $35 billion State of Wisconsin Investment Board, Madison, which manages its money internally. Executives there have little faith in the capabilities of consultants who measure trading costs, and have no intention of using them.
Still, fund officials are confident they are getting best execution, said James Severance, portfolio manager.
Meanwhile, the $35 billion New Jersey Division of Investment, Trenton, which manages its money in-house, hired a consultant three years ago to conduct a detailed analysis of its costs for every trade for an entire month. Said Roland M. Machold, director: "We actually came out with negative transaction costs."
Now, the fund conducts a rough trading cost analysis in-house, Mr. Machold said. Every week, the state fund compares the average price for its stock trades against the high and the low price for the stock during that period. The fund directs about 70% to 80% of its commissions - $5 million to $6 million on domestic stocks and $3 million to $4 million for international trades - to firms that pick up the tab for research services. Executives usually find the fund bought stocks at or less than their weekly median price, and sold them at slightly higher than the midpoint, Mr. Machold said.
