RET'ISTTING DIRECTED BROI(ERAGE: STTLL NCD FREE LUNGH A 7996 Plexus study of one clrent's drrected and non-dtrected trades concluded that whrle drrected trades had lower tmpact and commisslon cosrs, trmrng and opporlunity costs outwelghed the sav- ings. More importanLly, drrected lradlng discourages lradrng rn raptdly movrng sltuattons. leadtng to significant underperformance relatlve to non-dtrected trades. Thls follow-up study of more clients and a longer time frame, comes to slmrlar conclusrons that [7J dlrected trades show no cost advantage when adjusted for expected costs, ancl [2J rndrrectly emphaslzrng lower cost trades leads to lower returns than reallzed throuqh non-dlrected trades.
How many sponsors would agree that NYSE Rule 122 specifically prohibits higher commissions can lead to a member firm from trading a stock with
Plexus now has r"-rp to nine quarters of
many, we suspect. "...CgptUring 3( Of COtn- broker at a time. directed trading data for eight clients. Sponsors who cap- Since the trader's This sample provides both a deeper mission ture commissions cost the direct- iob is to control pool for comparison and a good cross- forfundadministra- ing sponsors 10.3( of , 'information flow section over time. The sample in- tion implicitly be- perform&nce..." to brokers in a cludes both large-cap and small-cap lieve that a higher way that secures as well as value and growth strate- commission buys nothing of value. best execution for all accounts, seqllenc- gies. ln 1Q98, the sample included Consequently. rnanagers continue to ing of directed trades naturally results. $48 bil. of decisions of which 22% feel pressure to direct commissions represented directed decisions. When prices move rapidly, timing to designated brokers for sponsor use. Because the analysis covered a becomes a priority. Accounts that di- The burden ofproof that commissions broader range of investment styles, the rect trades to specific firms lose timing can be a tool, not just a cost, has effects of delays were reduced. Tim- advantage whrle recapturing cornrnis- fallen on the manager. Managers in- ing costs for directed trades fell, com- sions. How are we to assure this tradeoff tuit that direction alfects investment paring more favorably to the non-di- is in the client's best interest? perfomance, but seldom possess suf- rected trades. However, the bench- ficient information to demonstrate mark costs for directed trades also fell. that they are using commissions ef- As a result, directed trades lagged fectively. The 1996 Plexus study of a growth their benchmark by 400%, compared Measuring the true cost of direction manager's directed trading showed to 8% for non-directed trades. requires looking beyond the obvious that: An interesting finding was that im- costs of commissions and direct im- o Directed trades cost more than pact and commissions converged for pact. It needs to include timing costs non-directed trades; 1 I 2 bp as con- the two groups of trades. Directed incurred while a directing broker trasted to 83 bp. impact * commission costs rose from seeks or awaits liquidity, as well as 25 to 2l bp, while non-directed costs foregone returns when liquidity fails o The ratio ofcosts to expected costs fell from 39 to 33 bp. This is consis- to develop. These costs capture the were more unfavorable for directed tent with the steady drop in average effects of disruptions to a manager's trades: 560 o ove r expectation com- commission rates due to increased use normal execution strategies. While pared to 40o over expectation. of Proprietary Trading Systems such proponents of direction argue that di- o Serious problems developed in ex- as lnstinet and ITG/Posit. The ques- rection should not disrupt a manager's tion appears to be no longer the level perienced net returns, -3.l9oA for process, we show that differences re- of commissions; rather how the com- directed trades vs. +0.470% for non- sulting from the sequencing of trades missions are used. directed. As a result, directed ac- can be significant. counts realized lower returns for traded shares. Returns: tlre Bottorn Llne fon The News! In the first study, we concluded that the On a cumulative basis, non-directed most damaging aspect of directing bro- trades retumed +212 bp versus a loss Take a look at our new Website at kerage was the 'adverse selection' in- of 87 bp for directed trades. Consis- www.plexusgroup.com. Find out cured when directed brokers fail to ac- tent with theory, directed trades out- more about Plexus. study past cess liquidity in last moving situations. performed in only one period -- a commentaries, and soon access Because our first study covered a growth/ quafter when average decision returns Plexus Group services online. momentum-oriented manager, missed were negatlve. trades led to a large difference in retums" The "Plexus Group Sixth Con- Momentum-style managers and small Adding more styles dampens the differ- ference Summary" is now arrail- ential. but the perfonnace gap persists. cap managers appear to need all the broker flexibility and cooperation they ablelWrite to us for a free copy, The significant difference for plan can muster. Value managers, however, 0r e-mail your request to sponsors again occurred in the realized find time delay can be an ally, and di- info@plex usgroup.com. rates of return frorn trading. Market- recting may result in serendipitious de- adjusted 30-day retllrns for directed lays. The exceptions are worth know- trades averaged bp versus +23 bp ing to a sponsor who wants to effec- for non-directed-10 trades. tively direct commissions. Upcoming Speeches
Gonclusions ary 25-26. New york:
iunu "New Technologies The table below summarizes the re- The lesson is that effective direction of tWayne lhagner) sults. The benefits of recaptured com- trading requires careful planning. Plexus "Measuring Best Execution" missions, assumed to be 3l per share, Group recommends: (Steve Glass) are added to gains which arise because smaller directed trades have lower com- 1' Direct only a modest portion of mission and impact costs. oft'setting commissions(10-30%)basedonboth CBOE, Risk Management and capitalization' For these gains is the finding that directed manager style January 27 -30, Scottsdale: trades are more costly compared to their example' a large-cap value manager "Managing Transaction Costs" can tolerate more directed trades than benchmark (of what they should cost). (lVayne Wagner) Finally, the performance of directed a small-cap value or large-cap growth trades suffers when they are delayed or manager' too 2. Choose directed brokers in consulta- abandoned because prices moved quickly. The performance penalty tion with the manaser. Reprint any portion of this amounts to almost 15d per share. 3. Use steo-outs as an alternative material with credit given to: Adding all the components together, the study shows that capturing 3p of com- 4. Consider whether the seruices pur- mission cost tlle directing sponsors chased are essential to manager plexuggroue 10.31 per share of performance relative performance. to non-directing accounts. 5. Install a monitoring program to evalu- 11150 W. Olympic Blvd., #900 ate executions and perfotmance. Los Angeles. CA 90064 PH: 310.3 12.55A5 len-Oiree+cC , FAX: 310.312.5506 TRADING PERFORMANCE i+aCe+ . nHl;. Also available at 3 0c 3 0( rvrvw.p lexus group. c om. i 0 0c
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@ Plexus Croup, 1998 E 4 50 l6 2C il7e U nderoerformonce ot oirecied trodes due to delovs l0 3c -4 5C l4 8C ond missed trodes