Questions over dark pools prompt changes in best execution

Money managers and consultants are looking at best execution beyond best price, spurred by clients wanting more details on how their trades are made.

Recent investigations into dark pools and high-frequency trading are causing institutional investors to reconsider just what constitutes best execution — and how to measure it. And the pressure to convey that to asset owners is falling on money managers and investment consultants.

It has always been incumbent on the “buy side” to monitor best execution, said Henry Yegerman, director of trading analytics and research at financial data provider Markit Group Ltd., New York.

“With the events of the last six months or so, with "Flash Boys' and the Barclays lawsuit, asset owners have heightened sensitivity to the need for transparency and now are getting more proactive at peeling away the onion,” Mr. Yegerman said.

“Previously, (best execution) stopped at the buy side, but now everyone needs to look at the overall financial food chain, from asset owner to manager to broker, to make sure they really are getting the best execution,” Mr. Yegerman said.

(The book “Flash Boys” spotlights what author Michael Lewis wrote was the unfair advantage of high-frequency traders in dark pools; Barclays PLC is being sued by Eric Schneiderman, New York state attorney general, on charges of building its dark-pool trading business on false claims and fraud, favoring high-frequency traders. Barclays denies the charges and the lawsuit is pending in New York State Supreme Court.)

Tim Barron, senior vice president and chief investment officer, Segal Rogerscasey, Darien, Conn., said, “People are in the exploratory stage.

“The fact that trading has been in the news so much is the reason for all the back chatter. Asset owners have had a substantial reliance on their asset managers. Now trading is a lot more complex. The world of trading has changed dramatically in the last decade. For example, 10 years ago, there weren't any dark pools. The changes require that clients — and consultants — relearn about trading and how trading relates to fiduciary responsibilities. There are more elements (in measuring best execution). That's the part we all have to get more educated about.”

Added Richard Kos, founder and president of investment and fiduciary consulting firm Kos Consultants, Madison, Conn., “We're getting more sophisticated.”

Volume-weighted average pricing, a common method of measuring execution, “is a great proxy, but now we're getting to a new standard, measuring market impact and timing cost,” Mr. Kos said.

That standard hasn't been reached yet. The buy side is considering ways of using benchmarks such as VWAP and implementation shortfall, also called liquidity charges among traders, in different ways to get more transparency on execution. Key to those decisions, Mr. Kos said, is determining what the portfolio manager wants to do. He said patient and more contrarian value-oriented equity managers have a “VWAP mindset,” while growth equity managers, who trade more quickly and timely, use implementation shortfall.

“VWAP is great over time, while implementation shortfall is more specific to the trade or the type of manager,” Mr. Kos said.

The complexity of what conveys best execution is another issue for asset owners, Markit's Mr. Yegerman said. “Part of the problem is that asset owners are looking to get a single number, a "magic bullet,' that will benchmark best execution. The reality is that it's not that neat and seamless. Is it how much you pay or how much of the order is traded? It's not really as black-and-white as they want.”

Ryan D. Larson, Chicago-based head of U.S. equity trading at RBC Global Asset Management (U.S.) Inc., said: “We're definitely making more active routing decisions on a pre-trade basis and looking at more trade oversight holistically.

“Many considered best execution to be best price and lowest fees, all a matter of cost. But it is far more than that. The process not only involves cost, but venue analysis, what the portfolio manager's intent with the trade is, its input from traders, risk management, compliance and trade oversight. All of that matters in today's environment,” Mr. Larson said.

Added Eric Hess, managing partner at New York-based Hess Legal Counsel LLC: “The buy side generally is starting to take a more holistic approach to best execution, with a whole host of things to consider besides executed price that can't always be quantified. Information leakage, for example, is a difficult variable to quantify.” Hess Legal Counsel advises broker-dealers and money management firms.

The heightened interest in disclosure is good for money managers as well as asset owners, said Phillip Krauss, head of equity trading, BMO Global Asset Management, Chicago. “All asset managers and clients should be concerned about disclosure. For us, our view is the more disclosure, the better. Investors should be able to see where they're trading, and determine which venues might be toxic.”

Mr. Krauss said the number of broker-dealers that managers use makes it cumbersome to monitor where they trade. “We work with 66 broker-dealers, and with that many it's hard to monitor what their execution venues are,” he said.

“We take the top 15 broker-dealers we use by volume, which constitute about 70% of our commission business, and we request execution venues from them and then we look at that, and check if any venues aren't doing best execution and have a liquidity charge” to see if there was any information leakage that affected the execution, Mr. Krauss said. “The lower the charge, the better the execution.”

Mr. Krauss said measuring a liquidity charge “isn't widely used,” even by larger money managers, with most doing best execution measurement via VWAP. He thinks more institutions will follow suit with using liquidity charge as a benchmark for best execution, adding liquidity charge measurement that's closer to real time is not far off: “It's going to go there. No one is doing that yet, but it's going to happen.”

From the institutional investor's perspective, what best execution means hasn't changed, but how it's monitored has, said Joan Stack, head of equity trading at the $75 billion Ohio Public Employees Retirement System, Columbus. “Best execution still means seeking the best all-in price available under prevailing market conditions,” Ms. Stack said. “But there is a higher degree of monitoring and surveillance required in the current environment.”

OPERS is “working more closely” with third-party transaction cost-analysis providers “to get ever greater levels of detail on trade routing, and looking very closely at the execution venue reports provided by our brokers.”

At the $26.1 billion Employees Retirement System of Texas, Austin, the pension fund “has not changed its practices ... because we were already aware of these areas of concern,” said Charles Thomas “Tom” Tull, chief investment officer. He said the pension fund, which like OPERS has an in-house trading platform, uses multiple best-execution benchmarks, including VWAP and implementation shortfall.