Getting alpha (or not) from equity execution

Updated with correction

Equity trading strategies increasingly are being seen through the lens of investment performance, with some sources referring to savings from reduced trading costs as alpha, not unlike what's obtained from excess investment return.

“There are hundreds of measures out there” for transaction costs, said Peter Weiler, executive vice president at Abel/Noser Corp., New York. “The trade data today is so much more robust, even things like fill analysis in milliseconds and microseconds. All of this has improved to the point where we can really pinpoint the short-term alpha sources in how trading is done.”

Such analytic systems are looking at ways to get best execution along with lower costs. And though the basis-point increases can amount to as much as 84 basis points on average, sources said, they can add up to additional millions of dollars when trading large numbers of shares.

That means most money managers aren't looking for home-run hitters in equity trading, said Vincent Ficca, head of equity trading at Eagle Asset Management Inc., an equity and fixed-income manager in St. Petersburg, Fla.

“The goal is to be a singles or doubles hitter,” said Mr. Ficca. “What I want (as a trader) is to solve my portfolio manager's dilemma to put money to work efficiently. I need to understand when to be aggressive, when to back off, and when to change venues.”

Being able to solve that dilemma is made easier through the creation of analytical systems from firms such as Bloomberg LP, Abel/Noser and ITG. Those systems broaden traditional transaction cost analysis, with its focus on volume at a weighted average price, to incorporating a variety of benchmarks to look at the full life cycle of a trade, from a portfolio manager's original order to execution and post-trade.

Michael Falk, principal at Focus Consulting Group LLC, a Long Grove, Ill., money management consulting firm, said knowing where trading costs are coming from makes it possible for money managers to find better ways to execute a trade and pass on the savings to the portfolio and, ultimately, the asset owner.

“The focus has been recently on the active vs. passive issue because of the cost, but they (asset owners) ignore the trading cost,” Mr. Falk said. “Management fees don't include the trading cost. A manager with 10% turnover in a year vs. a manager with 200% turnover in a year — if both charge a 1% trading fee, one is going to be a lot more expensive than the other.”

Whether the cost savings from these analytics can be called alpha is a point of contention among the analytics providers.

Vlad Rashkovich, global head of quantitative trading strategies at Bloomberg, New York, said performance attribution terminology that applies to investments can be applied to trading behavior, making it more relevant to portfolio managers.

“From the portfolio manager's perspective, trading looks like a black box which has 200 benchmarks and it's very confusing because you don't get one answer,” Mr. Rashkovich said. “On the flip side, in portfolio management, it's very well defined what the alpha is, what is your risk, what is your Sharpe ratio, so it's easier to conceptualize portfolio attribution.”

Mr. Rashkovich developed Bloomberg's Trading Alpha Frontier, which he said uses the same methodology as portfolio management but “with the attributes and the mindset and everything else from trading” — namely execution time, volume and price.

In Bloomberg's TAF, speed has the highest weighting on the frontier — 83% — similar in weight to the importance of a portfolio manager's stock selection ability, Mr. Rashkovich said. Two other measurement elements in the frontier, maneuvering and liquidity sourcing, make up the remaining 17%. The maneuvering required by a trader to find the best venue for execution parallels in importance the allocation strategy of a portfolio manager, while a trader's liquidity sourcing would more closely resemble a manager's foreign-exchange pricing.

“That's what trade performance attribution does,” Mr. Rashkovich said. “It attributes where alpha in trading is coming from correctly, and it makes sure it adds up to one story. So it presents the entire painting as opposed to a couple of disconnected brush strokes.”

Eagle Asset's Mr. Ficca agreed that while all elements are important, speed is predominant: “It's basically determining whether to speed up, slow down or stop.”

At Abel/Noser, Mr. Weiler said the firm provides an “alpha profile” of each portfolio manager, depending on the kind of strategy each runs, from growth to value to “neutral.”

“We provide manager profile charts with all trading activity,” Mr. Weiler said. “We also look at trading and its effect on portfolio performance. We look at the tradable portion of the portfolios and see if the trades that were made added alpha. That way, portfolio managers and trading desks can tweak their strategies if they need to.”

Abel/Noser's alpha profile is “like a playbook where portfolio managers could talk about the profile and tweak some things on their trading strategy,” said Mr. Weiler. “If you're losing 50 to 60 basis points because you're trading at the wrong time, for example, that will get their attention.”

Ian Domowitz, managing director and head of analytics at Investment Technology Group Inc., New York, said that while there is the potential for short-term alpha from trading strategies, the firm's analytics focuses more on alpha preservation than alpha generation. “Our algorithms will predict price movements in short intervals, but in the transaction cost analysis arena we focus more on preservation rather than predictive capabilities,” he said. ITG will incorporate expected transaction costs into overall portfolio construction to potentially increase overall return.

But Mr. Domowitz said that shouldn't be characterized as alpha.

“If I were confident I could add alpha from a trading strategy, I don't think I'd be working at an agency broker,” he said. “I'm not saying it's impossible to add alpha. However, if you do (the same strategy) over and over again, the averages are definitely negative.”

Mr. Domowitz said short-term alpha is available “when other folks are trading the same security over the same time period. Trading discloses information, and the more people in it drives the price up. If you're on top of that, you can gain some basis points.”

From the trader's perspective, using analysis in trading strategies to gain an advantage in execution is crucial, said Eagle Asset's Mr. Ficca. “If I find 10,000 shares at 2 cents at 10 minutes but then find those same shares at 1 cent over one minute, I've created alpha,” he said.

“There's lots of granularity in trading,” Mr. Ficca added. “The bid/ask (spread), is it lit or dark trading, what's the duration of the trade — that's a lot of data. It's important for me to match the tools of a trader and get the best chance to get the best volume, the best price, find the right venue and not overbroadcast our intent. ... All of these (tools) are arrows in our quiver.”

Mr. Rashkovich said just as with investment performance, knowledge is power for institutional investors who watch trading costs.

Mr. Rashkovich said an asset owner can say, “"Yeah, I don't care.' That's valid. But it's the same thing ... (as if) you invested in a portfolio manager. You say, "I don't know. They return me 15%. I'm happy.' But don't you want to know that they invested in junk bonds and they took a lot of risk, and then they were good in choosing the bonds, but the sectors they have chosen or the ratings or maturities were not optimal? Don't you want to know the underlying story?

“So the same thing is here. You want to say, "Yeah, your performance looks great, but I have no idea what you're doing. Let me take a look.' And (then) you say, "You know, guys, you are great portfolio managers but on the trading side I think you're losing money,' or, "Your traders are fully aligned with portfolio managers. That's great, but they are trying to trade too much, if you will.' In other words, they maneuver a lot. They just frontload and backload and this and that, a lot of dancing around. And when they do that they take risks that don't pay off.” n