Best execution a real conundrum

Market participants agree on the principle of best execution in trades. But how they define best execution is another story.

For some, it's the best price for a trade; others see it as the overall trade value; others look at the time it takes to conduct a trade; still others consider it commissions; and yet others see it as avoiding implementation shortfall. It's those differences that make creating a single prescriptive definition of best execution difficult.

Those different views can be costly to market participants - from asset owners to brokers to money managers — who might focus on one aspect of best execution while ignoring others that lead to inefficient trades.

And if differing definitions aren't enough of a problem, add in the fact that that institutional and retail investors have “very different” views about best execution, said Steven Glass, president and CEO of Zeno Consulting Group LLC, Washington, a trading consultant to pension funds.

Mr. Glass noted that for institutional investors, what matters is: “At the end of the day, what trading process maximized the value of their portfolio?”

“Looking at best execution through microstructure may not be in asset owners' best interest. On the retail side, their issues are being looked at” by the Securities and Exchange Commission's Equity Market Structure Advisory Committee. “Their orders are small. They don't have the same challenges that institutions have,” he said.

“But unfortunately, markets are for everyone, large and small.”

Added William Moriarty, president and CEO of University of Toronto Asset Management, Toronto: “Every trade has to be put in context, what (trades) are liquidity providing or liquidity demanding. You cannot define best execution in an absolute sense. You can create a framework that's more principle-based than prescriptive.”

UTAM manages C$6.5 billion ($5.4 billion) in assets for the University of Toronto, including C$3.7 billion for its defined benefit funds and its C$2.5 billion endowment. Mr. Moriarty is a former chairman of Market Regulation Services, a self-regulating organization that oversaw Canadian exchanges and automated trading systems. It was combined in 2008 with the Investment Dealers Association of Canada to form the Investment Industry Regulatory Organization of Canada.

Mr. Glass said a definition of best execution applicable to asset owners matches one provided by the CFA Institute, whose Trade Management Guidelines state that best execution is “the trading process ... that seeks to maximize the value of a client's portfolio within the client's stated investment objectives and constraints.”

“Under that definition, you're looking at a much higher-level picture,” Mr. Glass said. “For my clients, this is a much better definition. It gives the manager discretion to choose venues, and it allows for the inclusion of what the cost of information leakage could be that ultimately could make the trade have less value even with the best price.”

Rob Agne, director, head of product management at Eze Software Group, Boston, a provider of order and portfolio management systems, has his own definition.

“For asset owners, best execution is the best possible way to trade during the lifecycle of an order, from pre-trade to post-trade,” Mr. Agne said. “It's also determining the intersection between execution and commission-sharing arrangements, to make sure policies and procedures of trades are truly providing best execution for asset owners.”

Defining what best execution is has been a difficult exercise, going as far back as the 1980s, when the SEC defined it as the best bid/offer from national exchanges, “driven purely by price,” said Richard Kos, founder and president of investment and fiduciary consulting firm Kos Consultants, Madison, Conn. He said the agency lately has added the time of a trade as a means of measuring best execution, but still the SEC has not fully defined the overall concept.

According to the SEC, best execution involves the full range and quality of a broker's services, including the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the end client.

However, Mr. Kos said: “The concept is too nebulous for the SEC to enforce. The SEC's concept is that best execution is the best price given the unique situation of a trade. They'll have to come up with some kind of definition beyond that, but to be enforceable, it'd have to be dumbed down to a price focus. That's very measurable in equities. But when you get into derivatives and fixed income, it starts getting kind of dicey. The SEC has gotten better on that with some regulations, but they're still tough to measure.”

William Gartland, senior director at Interactive Data Corp., a New York-based financial data provider for custodians and money managers, said regulators' lack of a uniform best-execution standard is a problem for brokers as well. “Brokers want definitions. Regulators want data they can use to look for patterns of abuse,” he said. “But with the evolution in market structure toward electronic venues, does that mean there'll be changes in regulation? That causes friction with brokers because (regulators) don't get very definitive. With money market funds, for example, regulators have called for a floating NAV (net asset value). But how do you implement that? Regulators do walk a fine line.”

VWAP (volume-weighted average price) “seems to be the market best practice in equities,” Mr. Gartland said. “But with fixed income, this falls apart. What do you do if you're the only trade? There's nothing to compare against. There's nowhere near the traffic you have in stocks, futures or foreign exchange. That's a big question a lot of people are trying to address. We need to account for execution quality and price quality.”

Three quotes in fixed income had historically been best practice, Mr. Gartland added, “but if you poke at that, you can see some weaknesses. ... If you're a large money manager, you can't just use one or two brokers. You'd need a variety of brokers to be sure you can find liquidity and inventory when needed. ... It used to be "I know, I have three quotes,' but that doesn't satisfy compliance officers any more. Fixed income warrants its own approach.”

Another particularly thorny issue for asset owners is implementation shortfall — when a security is traded at a lower price than what was expected when a decision on making the trade was made, said Henri Waelbroeck, director of research at execution management system provider Portware LLC, New York.

“To institutions, time and size (of a trade) are the same problem,” Mr. Waelbroeck said. “This is an issue for many market-traded securities, not just equities. For the institutional investor, best execution means minimizing implementation shortfall. Also part of that are limits on price and opportunity costs.”

Regulators have responded to concerns about best execution as they have for other issues involving trading: by requiring more transparency. Efforts such as the SEC's panel and European rules under the Markets in Financial Instruments Directive are focusing on brokers and trading venues providing more data to the buy and sell sides, intending to ensure fairness in the markets and enhance disclosure on trade execution.

“There'll be dramatic enhancement in the transparency of execution quality,” said Chris Concannon, president and CEO of BATS Global Markets Inc., New York. “It's not enough to do best execution; now it'll have to be proven. That used to be just on retail trades, but now you're seeing demands from institutional investors to professional traders. They want to know about the cost of the trade, the price, the routing, and all of that will have to be detailed to them.”

Mr. Concannon said SEC Chairwoman Mary Jo White and Stephen Luparello, SEC director of trading and markets, “have talked about the enhancement and standardization of transparency for large institutional investors. That's a dramatic change for the historical perspective of the SEC. For 30 years the institutional investor (asset owners and their money managers) has been seen by the SEC as a professional trader who needs no help. Now for the first time, (the SEC) is saying that markets have become so complicated, even professionals need more transparency.”

The view that added transparency will benefit institutional investors isn't shared by all. Adam Sussman, New York-based senior adviser, head of market structure and liquidity partnerships at dark-pool operator Liquidnet Holdings Inc., thinks transparency has “been the default solution” for the SEC.

“Requiring this is easier for the industry,” Mr. Sussman said. “Give the customers all the information and let them decide. It's tough to set up best-execution rules across all asset classes and all clients. Ultimately you'll have to push the responsibility for this back to the end user.”

With added transparency, all participants, including asset owners, will need to grasp what best execution means to them and to other market participants, said Kevin Cronin, managing director and global head of trading at Invesco Ltd., Atlanta, and a member of the SEC equity market structure panel.

“Let's be careful with what we're trying to do,” Mr. Cronin said. “All participants in a trade, from managers to brokers to venue, have a responsibility in this. And it's ultimately up to the client to make sure trades are done well. It gets down to the illumination of the process and how managers manage money - and part of that is how they transact. It's important for asset owners to understand the responsibilities, make sure they're understood.”

At UTAM, said Mr. Moriarty, officials ask external managers to provide trade reports periodically, but they do a deep dive into their execution and measurement systems before managers are hired.

“We look pretty carefully when allocating assets to managers,” Mr. Moriarty said.

“As part of our due diligence, we want to see if the manager has a system in place, and not just words on paper, to be sure they monitor execution, for cost and other things, like the size your trading, (whether it is) an illiquid market, Mr. Moriarty said.

Once hired, information requested by UTAM regularly includes “the amount traded, the costs including commissions but also other ancillary costs, and how trades went relative to the VWAP or implementation shortfall,” he said. “It's all about just trying to understand the policies and procedures when funding a mandate and then making sure they follow through.”

Invesco's Mr. Cronin and Joseph Ratterman, Kansas City, Mo.-based chairman of BATS and a member of the SEC equity market structure committee think one definition of best execution is not the way to go.

“There are so many investment processes in the world,” said Mr. Cronin. “Just in equities, there's growth, value, core. It would be a bad idea for regulators to say what the best kind of investment is. It's the same with best execution: it would be a bad thing to say what makes best execution.

“The theory behind best execution is that it's a responsibility to make sure the trading process is focused on getting the best value for the client.

“You have to start with the recognition that trying to define best execution just one way isn't right. For example, everyone manages money differently, and it's equally hard to say that one benchmark is the right benchmark for everything, since investment strategies all have different objectives and goals. Trading is the same. To think that there's one magic number out there for best execution, well, it doesn't work that way. I've been looking for years and I can't find one. I'm just being realistic.”

Mr. Ratterman doesn't think the SEC committee “can do anything that would be beyond principles-based guidelines. The core tenets of that should be kept in mind, but it seems wise to keep best execution as is. Best execution for us might not be best execution for someone else.”