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.”