LOS ANGELES -- Decisions made by active money managers usually add value, but the value is often lost through the trading process, a Plexus Group study said.
Plexus studied 40 money managers representing about 25% of the trading volume on the New York Stock Exchange.
The main reason value is lost is that managers and traders often view the investment process from separate perspectives, each with different objectives and time horizons.
"We've found that managers tend to diversify and can't tell how any one investment will perform. And a lot of the (portfolio) return is generated by just a few ideas," said Mark Edwards, managing director at Plexus, Los Angeles.
"We find that for the big ideas, managers do a good job of selecting stocks. But, when the manager selects stocks, they need to get all their ideas executed."
That's where problems that detract from active money manager performance begin to unfold.
The role of the trader becomes critical once the money manager makes a decision on whether to step in and buy or sell a stock position. It becomes the trader's job to capture the investment idea in a timely manner and at minimal cost.
Also, traders must balance commissions and price impact on the trade completion, including timing effects generated from delayed trading and lost opportunity costs from abandoned trades.
According to Plexus data, about 55% of money manager decisions add value to the portfolio on average, but often are more difficult and expensive to execute.
At the same time, traders tend to pay more attention to commission costs than implementing the manager's ideas, according to Plexus.
"The problem is that active managers have been so browbeaten to minimize trading costs that active traders often won't pay up for stocks that are rising and wait until stocks come back to them, and buy stocks that are falling more quickly," said Mr. Edwards.
"Traders often seek to buy the cheapest stocks; they are trying to minimize costs because that's what they've been told to do."
Two different thought processes are at work, he said.
While the money manager may view a particular stock buy as a potential long-term contributor to performance, traders often view the purchase as a difficult trade and may delay the trade hoping for a better price. On top of that, traders are facing several trade orders from other buyers.
"To the manager, the risk is not achieving the expected price growth based on his fundamental research over the longer term. To the trade desk, the risk is a poor trade relative to recent trading ranges, which is usually a much shorter time horizon," said Mr. Edwards.
"The problem is that the trader doesn't understand that the manager's information overrules the information value of recent trading ranges," he said.
There is a "disconnect," he said, since managers focus on their "holding horizon," most often in years, to determine their selections, while traders focus on a much shorter time period -- days -- to frame their trading decisions.
"More simply stated: Managers seek maximum decision returns while traders seek to minimize trading costs," Mr. Edwards said.
As a result, often the best decisions of the money manager, the "home runs" with strong short- and long-term gains, are the slowest to be implemented, causing performance to suffer because of high delay costs.
Large orders may take from three to four days to up to two weeks to execute, he said.
Traders, hoping prices will reverse, often are reluctant to execute buys on stocks whose prices are rising and sells on stocks with falling prices, said Mr. Edwards.
"Eventually, they often take their lumps and pay up."
The result, according to the Plexus study, is that trader-timing delay costs averaged 113 basis points compared with only 24 basis points in actual brokerage impact and commissions.
Also, Plexus found that avoiding costs early created greater costs in the end. Much of the problem associated with problem trading occurs when traders and money managers recoil from decisions because of high commissions and impact costs that result in lower returns, said Mr. Edwards. By avoiding commissions, costs haven't really dropped but have shifted to the more "insidious" costs associated with delay and lost opportunity costs.
Missing best ideas
"Worse, when traders avoid the rising buys and falling sells, they miss the best ideas," he said.
"The shares not traded at all beat the traded shares by a market-adjusted 235 basis points. Not buying a winner is an opportunity cost; not selling a loser is an inventory loss. While both are bad for performance, the latter quickly ends up as a loss for the client," Mr. Edwards said.
According to Plexus, when a manager gives a trader a list of buys and sells, "he assumes that the trader will execute the entire list." However, during that time, some stocks will rise in price, some will fall and others will remain relatively flat.
"We find that those stocks that fall the most remain weak over the next 30 trading days. Conversely, those that rise the most continue to rise. There may be some reversion, but only 20% of these subsets actually reverse," said Mr. Edwards. "The smart money is on price persistence."
The answer, said Mr. Edwards, is for money managers to incorporate trading into the stock selection process.
To ease the situation, he said, there should be stronger manager/trader communications, especially about "manager motivation and market conditions."
Traders should "prioritize trades within the confines of the marketplace. Don't sit back and bet against the market," he said. "If you do bet against the market, you had better make it a good bet. The market is smarter than any one trader. Do the hard trades first."
Managers should give traders "a sense of the urgency and timeliness" of the trade, he said, and "never, never, never put limit orders on the trader, because no one knows what the market price should be."
Limit orders, said Mr. Edwards, "give the market a free option; you are giving the option for someone to trade against your limit."
Also, he said, traders "should try to trade everything."
Both parties should recognize that positive momentum on buy orders tends to confirm the money manager's decisions while increasing the trading difficulty, which often causes traders to defer trading "to the detriment of performance."
The trading desk should pay more attention to how the market responds to trading activity. "If the response is consistent with the manager's information, trade more aggressively. Traders who avoid market impact let the market, rather than the manager, choose the bet," he said.