NEW YORK - Institutional bond managers are gaining access to the same type of trading-cost analysis systems that are staples to equity managers.
Elkins/McSherry LLC, a New York-based trading-cost analysis firm, just introduced a program for global fixed-income securities designed to help cut transaction costs and improve portfolio returns in the process. And Plexus Group, a transaction analysis and consulting firm in Los Angeles, will introduce its first fixed-income transaction-cost analysis program later this year, said David Hall, president and chief executive officer of Los Angeles-based Plexus Group.
Trading costs and best execution have taken on growing importance among equity managers seeking to lower transaction costs and boost incremental returns after being hammered by three down years in the equity markets. But such analysis has not been widely available for bond managers. The problem has been the fragmented nature of the bond markets, the lack of intraday bond pricing and trade data, according to fixed-income managers.
Trading costs can range from 15% to 25% of fixed-income returns, according to Richard T. McSherry, chairman of Elkins/McSherry. The lackluster performance of global equities during the last three years has increased institutional interest in fixed income, making trading cost analysis even more important, he said.
Before introducing its global bond trading cost analysis package, which it is calling an industry first, Elkins/McSherry conducted a study of more than 25,000 anonymous bond portfolios from State Street Bank, Boston, which owns a majority interest in Elkins/McSherry.
In its review of the 25,000 portfolios, Mr. McSherry said volatility, or the cost of trading global bonds, ranged from an average of 22 basis points in Japan to 47 basis points in Germany, to 53 basis points in the United States and 62 basis points in the United Kingdom.
"Volatility is the key," he said. "It's the most significant cost of trading bonds, not the spreads; it's the volatility or the timing of the trade," he said. "Pricing fluctuates throughout the day and the spreads may be three basis points, but when the price moves the spread moves with it. The cost of trading is associated with the timing." He said the Elkins/McSherry global fixed-income analysis program would enable money managers to clearly establish trading costs for every portfolio and broker.
In the program's analysis, the cost of each trade is determined by comparing the executed price to the average of the bond on the day of the trade and to the Elkins/McSherry trading cost universe. "If you have two brokers with a similar mix and trading methodology, if one is 25 basis points higher than the other, where are those trading costs coming from?" Mr. McSherry asked. "Trading-cost analysis can tell you down to the bond level where those costs are coming from." The analysis covers 32,000 bonds in 42 global markets, he said.
The program is designed to tell money managers and pension funds whether they are paying too much in trading costs in global fixed-income markets, said Mr. McSherry. Institutional traders send trade data to Elkins/McSherry daily, he said, from which the system captures execution and pricing on the day of the trade and compares that with daily average pricing in global markets.
As in the equity world, transaction costs can range from 1% to 3% of the value of the fixed income portfolio, he said.
"If a pension fund's assumed rate of return on assets is 7% to 8% and transaction costs are 1% to 3%, transaction costs can be somewhere between 12% and 37% of that assumption. Real benefits can be achieved by knowing what your transaction costs are and then use that information to help get the best execution," he said.
The reason fixed-income trading-cost analysis has been slow to catch on, said Messrs. McSherry and Hall, is the lack of information. "It's because of the way fixed-income securities are bought and sold," said Mr. McSherry "There has been no source of timely data, it's never been an open market. There is no tape as at Nasdaq or the New York Stock Exchange. But that's starting to change."
Mr. Hall said the lack of timely and reliable intraday bond trading information has slowed the growth of bond trading cost analysis. "The issue has been where do you get the data. Equities have organized exchanges and composite trading resources. We've never had that with bonds. There is some end of day transaction data available," he said.
But Plexus is working with some electronic venues and data sources to accumulate the data to introduce its transaction cost analysis program later this year.