1

Is Market Impact a Measure of the Information Value of Trades?

Market Response to Liquidity vs Informed Trades1
C. Gomes and H. Waelbroeck
Portware LLC
Abstract
We examine information, market impact and trade sizes using a dataset of institutional trades where
approximately 1/4 of the orders are labeled as having been created for cash flow purposes. We find that
during the execution the functional form and scale of market impact are similar for cash flows as for
other trades. After the trade is completed, the impact of cash flows reverts almost completely on
average in two to five days. For trades excluding cash flows price reversion is only a fraction of total
impact: for every size, the price after reversion is, on average, equal to the average execution price,
leaving no immediate profits after accounting for trading costs. Observed mark-to-market profits on
merged orders from multiple portfolio managers and Nasdaq-listed stocks suggest that these trades are
more informed than the average. Mark-to-market losses on cash flows, trades that follow momentum
and additions to a prior position seeking to take advantage of an improved price reveal the low
information content of these trades. The complete price reversion for uninformed trades suggests that
prices cannot be manipulated as assumed in no-quasi-arbitrage arguments for the linearity of
permanent impact. There is no permanent impact, only information that causes trades.
Keywords: Implementation Shortfall, Market Impact, Sunshine Trading, Fair Price, Market Efficiency,
Market Microstructure, Active Fund Management, Permanent Impact.

We thank N. Bershova, J. D. Farmer, J. Gatheral, E. Goldberg, D. Rahklin and S. Vilming for their insightful
comments. The views expressed here are not necessarily those of Portware, LLC.

1. Introduction and Theoretical Background

It is widely recognized that indirect trading costs cause a significant drag on fund performance, leading
80% of actively managed funds to underperform the market index (Forbes, 2012). Institutions are
aware of this problem and, in spite of the potential timing costs associated with the loss of informational
advantage, they choose to split their large trades into numerous slices and execute them incrementally
over time to try to reduce market impact (Chan & Lakonishok, 1995; Keim & Madhavan, 1995). As the
execution progresses there is a direct impact on price through the mechanical effect of the order on the
order book (Hopman, 2007; Bouchaud et al. 2004, 2009). But there may be also an indirect impact
originated from the effect of the execution on expectations of market participants. It is generally agreed
that although wider market information can come through many channels, indirect impact is the
mechanism whereby information is conveyed to the market through trade execution (Grossman and
Stiglitz 1980; Grosman 1989).
In this paper we aim to test some of the predictions of models that explore the roles of information and
mechanical effects on market impact. We use a dataset of 129,944 trades from 112 portfolio managers
or strategies to measure price reversion after a trade is completed. We find that the process of post
trade reversion continues for an amount of time is approximately equal to the execution time. The
expected return after reversion, or permanent impact, is such that institutional orders break even
after reversion. Cash flow trades revert much more strongly, more than compensating for the
implementation shortfall and quite often reverting completely. This evidence suggests that market
impact costs measure the short-term information value of a trade.
Understanding the mechanisms that shape market impact is important to develop optimal execution
schedules (Alfonsi et al., 2010; Almgren and Chriss 99, 2001; Almgren et al. 2005; Bertismas and Lo,
1998; Bouchaud et al. 2009; Obizhaeva and Wang, 2013; Hasbrouck, 2007; Criscuolo and Waelbroeck
2012, 2013) and for portfolio optimization to determine the optimal scale and turnover ratio for an
actively managed fund (Berk and Green, 2004; Schwartzkopf and Farmer, 2010). The current body of
literature comprises two schools of thought regarding the relationship between market impact and
information.
One school of thought refers to market impact as the market's attempt at pricing the expected value of
the information that led to the creation of an order. If the market were to know that a trade is

3
uninformed, according to this school it should be possible to execute it without impact2. At the
microstructure level, the offer price is the expected future price conditioned only on the information
that the next order arrival will be a buy, whereas the bid is the expected future price conditioned the
next order being a sell. In Hasbrouck's words, "orders do not impact prices, it is more accurate to say
that orders forecast prices" (J. Hasbrouck, 2007). Extending this view to the incremental execution of a
hidden order over time, market impact corresponds to the expected future price conditioned on the
existence of this order, which is only revealed incrementally as each slice is delivered to the market.
Different models present distinct assumptions on how each slice is priced. The insider trading model
considers the case where an investor has exclusive access to information (the insider knows the closing
price of the security in advance). Kyle (1985) shows that such an insider will maximize her profit by
executing at a constant speed until price reaches the informed price at the end of the session; at that
point everyone discovers the final price and there is no reversion. Fair pricing theory (Farmer et al. 2013)
(FGLW) considers the opposite case, where instead of having a single informed insider, a large number
of investors receive the same information signal. Their orders are aggregated into a larger metaorder
which is executed over time. Once filled shares are allocated to the investors at the average price. FGLW
show that these assumptions lead to a Nash equilibrium where metaorder sizes are such that their
impact matches the amount of information. This result is called "fair pricing" because the average price
paid to execute a trade is on average equal to the post-reversion price, so both the institution and
liquidity providers break even. We use the term information in this article to mean short-term
information only, i.e., the information associated with the event or signal that led a portfolio manager to
place an order on this particular day and time rather than a few days earlier or later. A portfolio
manager may be contemplating an idea for some time before acting on it and typically aims to hold the
position over months or years. Even if fair pricing is right and trading cannot be expected to produce
short-term returns after reversion, a portfolio managers trades may well be profitable over a longer
horizon.
The other school of thought assumes that agents, rather than being purely rational, simply adopt the
current price as a reference point and randomly place buy or sell orders. Slices from institutional orders
interact with the order book and cause impact according to the mechanics of a double auction market.
In the absence of reliable information on fair prices, the market adopts the new price as reference in
2

"Sunshine trading" aims to take advantage of this view by pre-announcing a trade so its execution can
proceed without further impact (Anat R. et al. 1991).

4
pricing further orders, and so part of the impact becomes permanent. In a slightly different version of
this model impact is amplified by herding behavior (Froot et al 1992, Cont and Bouchaud, 2000, Lillo et
al 2008): traders respond to a common signal and cause mechanical impact regardless of information.
The end result in terms of permanent impact depends on whether there are trades made in the
opposite direction to undo the mechanical impact of the original trades. The most basic within the
mechanical impact category are zero intelligence models, which aim to explain price dynamics at the
microstructure level assuming only random order flows and a double auction process (Farmer et al.
2005). Remarkably, zero-intelligence models correctly predict important statistical properties of the
order book (Hopman, 2007). More recently, Bouchaud, Gefen, Potters and Wyart (Bouchaud et al. 2004)
have showed that market data is more consistent with an -intelligence viewpoint where a very small
fraction of the orders are informed. This viewpoint is corroborated and made more concrete in a model
we will refer to here as the -intelligence model (Toth et al. 2011), where the order book is formed from
a random statistical stream of limit orders and market orders.. The market orders consume limit orders
near the current market price. As the authors show, over time this results in a V-shape of the order
book, i.e. the depth of the order book grows linearly with the distance from the midpoint price. It
follows that the impact of immediate market orders grows as a square root of trade size. The authors
use numerical simulations to study the impact of metaorders that are executed algorithmically over
time. Toth et al show that the market operates at a critical point between a sub-diffusive world
dominated by market makers where price fluctuations are mean reverting and a super-diffusive mode
where directional traders drive price trends. The recent phenomenon of micro-crises in market
microstructure (the largest of which was the flash crash in US markets in May 2010) can be compared to
other critical phenomena such as avalanches or forest fires.
The two schools of thought lead to slightly different predictions about the shape of the impact function
and about the amount of reversion after a trade is completed. According to the -intelligence model,
impact scales as a power of trade size ranging from =0.55 for very rapid executions (30%
participation) to =2/3 for slower ones (5% participation). In the slower case peak impact will be
+ 1 = 5/3 of the shortfall, after which price reverts by 25%. This implies that trades are profitable
after reversion. In contrast, fair pricing theory derives the impact exponent from the tail exponent
of the cumulative distribution of metaorders, which itself follows from the tail exponent of
information shocks as

2 1
1

= + 1 (Farmer et al. 2013). For = 3 (Plerou et al. 1999), this implies

that = 1.5; fair pricing theory predicts that should be equal to the tail exponent of the metaorder

5
1
2

size distribution minus 1, i.e. = 1 = . These results are consistent with the findings from order
splitting models that show how the metaorder size distribution creates order flow auto-correlation with
a tail exponent = 1 (Lillo et al. 2005); so the impact scaling exponent is predicted to be the same
as the auto-correlation exponent. Various studies have reported different values of the auto-correlation
exponents depending on the stock and listing market. Lillo et al. (2005) find = 0.53 for Shell; Toth et
al. (2012) find an exponent close to 0.5 for a set of liquid stocks from the London Stock Exchange; Eisler
et al. (2012) find = 0.7; Farmer et al. (2006) and Bouchaud et al. (2004) find the exponent to be in the
ranges of 0.52-0.57 and 0.2-0.7, respectively. Order size distributions have been found to have powerlaw tails with exponents consistent with = 1: 1.56 for a buyside firm (Bershova and Rakhlin, 2013)
or 1.7 for brokerages in the Spanish stock exchange (Vaglica et al. 2008). Taking = 1.5 as an example,
FGLW show that impact grows as a square root of trade size, reaches a peak of 1.5 times the shortfall,
then reverts by 1/3 back to the shortfall.
Empirical observations of the shape of the impact function have been discussed elsewhere (Almgren et
al. 2005, Engle et al. 2008) and generally confirm a power law with exponent in the range [0.4, 0.7]. Our
own estimates indicate that impact scales as a square root of trade size overall. We also find that the
scale of market impact during the execution is not significantly different for cash flow trades versus
other trades.
Our results on reversion are consistent with fair pricing for all order sizes excluding cash trades, with 1/3
reversion from peak impact. We also cannot reject the slightly lower prediction of 25% reversion in the
-intelligence model. As noted previously cash flow trades are not consistent with fair pricing: reversion
is much stronger and essentially eliminates impact completely.
These results suggest that both schools of thought on the nature of market impact are essentially right:
market impact is primarily mechanical during the execution process in the sense that it does not
differentiate informed from uninformed trades until impact has become quite large, but also, the
observation that reversion for non cash-flow trades is consistent with fair pricing shows that impact
reflects the average information content of trades.
We had to make some assumptions in preparing the data before deriving these results. We merged
overlapping trades and near-overlapping trades from the same firm on the same side into a single
metaorder and only considered for analysis those metaorders above 1% of the average daily volume in
the security. Additional trades in the same security that are clearly separated from the initial one, but

6
still within the window used to observe reversion, cause a bias in post-execution returns. To address this
issue, we used an impact model to estimate the incremental impact of subsequent trading and adjusted
prices by removing this impact from observed prices. The cash flow label is not available for all portfolio
managers in our dataset, therefore the subset of trades that are not labeled as cash flow trades may or
may not be originated for cash flow reasons.
Our methodology for merging orders has a lot of commonalities with other empirical studies of
metaorders that also combine multiple trades. Chan and Lakonishok (1995) introduced this concept in
an empirical study by treating an entire sequence of trades from the same manager spanning over
multiple days, albeit with some intervals, as their basic unit of analysis of market impact. Keim and
Madhavan (1997), Torre (1997) and Almgren et al. (2005) are other examples of a number of studies
that attempt to link sequences of trades that are part of the same transaction. Moro et al. (2009) take a
slightly different approach by inferring hidden institutional orders from the analysis of rates of execution
from different brokers. Bershova and Rakhlin (2013) looked at single-day trades from AllianceBernstein
and a third-party dataset that stitched together multi-day orders where the net accumulation was at
least 5% of median daily volume in each day. Our handling of the data differs to some extent from these
studies since we may aggregate trades across managers within the same firm and consider maximum
time gap of 60 minutes between trades that are aggregated across managers.
The response to trades with various information contents is of crucial importance to the market
microstructure literature but, empirically, the role of information on permanent impact has been
difficult to study due to lack of data. Llorente et al (2002) have emphasized the differential impact of
informed and liquidity trades but are only able to identify these trades separately by proxy (spread and
market capitalization). Obizhaeva (2007) finds that in the context of portfolio transitions, buys are more
often driven by information and have permanent impact while sells are usually triggered by liquidity
needs and suffer more pronounced reversion. Other examples include Alexander et al. (2007), Coval and
Stafford (2007), and Da et al. (2007) who analyze price responses to liquidity-motivated and
information-motivated trades of mutual funds, the information content of which is determined by fund
inflows and outflows. The authors have to use proxies for actual inflows, outflows and transitions, which
they construct from fund holdings and returns. Another set of studies investigate specific trades of
market participants that are most likely not driven by private information as, for instance, fire sales of
fund managers (Coval and Stafford, 2007), merger-induced trading of arbitrageurs (Mitchell, Pulvino and
Stafford, 2004), or changes in number of shares in margin accounts (Andrade et al. 2008). Although the

7
majority of studies find that eventually initial price deviations are followed by partial or complete
reversion, cases of permanent price changes or even continuations are documented as well.
Our empirical analysis adds to this literature by testing the predictions of competing models on the role
of information. We consider the mark-to-market P&L of trades at the reversion price by comparing the
price paid for the position to the price after reversion is complete. Fair pricing is the condition that the
P&L should be equal to zero on average for every trade size. As mentioned previously, our results
suggest that the fair pricing condition holds, confirming the evidence recently provided by Bershova and
Rakhlin (2013). But, for most trades, the point estimates of reversion are also consistent with pure
mechanical effects along similar lines as the -intelligence model. The observation of a much stronger
reversion in cash flows is the most difficult to reconcile with mechanical impact and gives more support
to the theory that the information content of trades determines their permanent impact. If this is true,
then it would follow that larger metaorders must be more informed on average than small ones.
We explore further the role of information by looking for significant factors that would cause deviations
from fair pricing in a regression analysis. A positive P&L is characteristic of metaorders that are too small
relative to the information, whereas a negative P&L represents overtrading. We find that trades that
follow intraday momentum, trade in large cap stocks and additions to a prior position seeking to take
advantage of an improved price are more likely to incur excessive implementation shortfalls relative to
their short-term information. On the contrary, Nasdaq stocks and metaorders that aggregate orders
from multiple managers tend to be profitable for the portfolio on a mark-to-market basis after
reversion, as do new trades in a stock where the portfolio manager has not been active in the last 3
months.
In the next section we will explain the data preparation in more detail and present the summary
statistics. In section 3 we provide formal testing of breakeven, efficiency and fair pricing. In section 4 we
explore deviations from the fair pricing condition. In section 5 we compare the predictions of the fair
pricing theory and the epsilon-intelligence model. We conclude in section 6 discussing the significance of
our findings.

2. Data and Summary Statistics

8
Our proprietary dataset comprises 129,944 metaorders larger than 1% of daily volume originated by a
total of 112 portfolio managers across several large institutional asset managers between July 2009 and
March 2012. Pre-processed data was extracted from OMS files and includes comprehensive information
on trade creation (time of order creation, portfolio manager and trade purpose) and details on
individual executions.
The metaorders result from merging overlapping trades and near-overlapping trades in order to
replicate what market participants can observe throughout the overall execution time. Some portfolio
managers send orders in multiple blocks, preferring to see the result of the first block before sending
the next. In other instances, a single research result from the firm can trigger order creations by multiple
portfolio managers. In these cases, each block is assigned a different order ID at creation time, but once
orders reach the trading desk they are usually merged into a single trade to be executed as a unit; the
fills are then allocated to portfolio managers at the average price. Even if the desk chooses to execute
multiple blocks separately instead of merging them into a single unit there is no way for market
participants to distinguish different blocks from the same portfolio manager or from different portfolio
managers since orders are sent to the market anonymously. Hence, the impact of the multiple orders
will be the same as for a merged metaorder.
We merge orders on consecutive days in the same symbol and side by the same portfolio manager, and
merge trade segments originated from a different portfolio manager at the same firm on the same
security and side that were either contemporaneous or less than 60 minutes apart, counting only openmarket-hours time. Approximately 25% of the trades in the sample are labeled as cash flow trades,
indicating they were created by a portfolio manager to invest inflows or fund outflows rather than being
triggered from any information signal. These trades are analyzed separately from the other trades; cash
flow trades can be merged with other cash flow trades but are not merged with trades that were not
labeled as cash flows. For each merged trade, we then compute the average realized price per share and
the final impact measured as the return from the mid-quote at the beginning of the first segment to the
mid-quote at the end of the last segment. We also consider returns to the same-day market close and to
the market close 1, 2, 5, 10, 20 and 60 days later, measured from the mid-quote at the beginning of the
first segment. Reversion after trade completion is estimated as the symmetric return from mid-quote at
the beginning of the first segment to the mid-quote at the time of the last fill.
Returns after trade completion may be significantly affected by the occurrence of additional trades in
the same security, which are clearly separated from the initial one or on the opposite side of the market.

9
In order to address this bias, we take the cumulative sum of all subsequent trades from the desk on the
same ticker on either side of the market executed within the time window until each market close
benchmark. We then estimate the net impact of the additional positions with a simple and robust
impact model [(Torre, Moro et al. 2009, Engle et al. 2008) which includes as main arguments the
annualized daily volatility of the stock in percent and the square root of trade size as a percentage of
average daily volume. The model is calibrated by setting the scale factor so that the average expected
impact is equal to the mean realized shortfall in our sample:
() = 2.6

(1)

The unbiased estimate of reversion until day t is derived from the observed stock returns from last fill
( ) to the market close at the tth day after the end of the trade ( , ), net of the estimated
impacts of the additional buy and sell trades

until that time. We consider up to 20 days

after the trade ends. Using logarithmic returns expressed in basis points,
= 10,000 ln , +

= + 0, 1, 2, 5, 10, 20, 60

(2)

We believe this method to be a superior alternative to restricting the analysis to metaorders without
subsequent add-ons since additional positions on the same stock are very common and the sample size
would be reduced considerably. For example, in our data only 20% of the trades would meet this
criterion. Furthermore, additional positions on the same stock are very likely to be non-random and
related market conditions so that restricting the analysis to the subset of trades with no trade
continuation would create selection bias.
From the original dataset of 129,944 metaorders larger than 1% of the average daily volume, we
consider the subset with duration of at least 5 minutes and a participation rate below 50% in order to
drop trades that are likely to be dominated by a block execution. We also drop trades with price below
$1 and volatility above 200%. Table 1 includes descriptive statistics of the remaining 27,581 cash flow
trades and 87,658 other trades. The results show that cash flow trades are smaller with a median size of
2.2% of average daily volume as compared to 5.1% for other trades; they are also executed more
patiently with an average participation rate of 6% versus 13% for other trades.

10

Cash Flow Trades

Other Trades

Median

Mean

Stddev

Median

Mean

Stddev

Average Daily Volume

285K

933K

2.78M

984K

3.01M

8.9M

Volatility [%]

34.63

39.61

20.9

32.97

35.84

16.14

Spread [bps]

12.04

22.66

38.48

6.65

13.15

25.88

Shares Executed

8,167

26,550

77,377

61,100

188,080

551,800

Size [% ADV]

2.2%

4.7%

9.4%

5.1%

15.1%

38.3%

Participation Rate [%]

3%

6%

10.4%

4.9%

13%

36.4%

Trade Duration [hrs]

3.28

4.41

5.25

4.38

6.01

11.2

Observations

27,591

87,658

Table 1. Descriptive statistics of metaorders. The median metaorder size is 2.2% of average daily volume for cash
flow trades and 5.1% for other trades. Cash flows also tend to be executed more slowly with an average
participation rate of 6% versus 13% for other trades.

3. Breakeven, Efficiency and Fair Pricing

3.1 Breakeven and Efficiency
In Table 2a we show the averages for several relevant returns. Shortfall is the difference between the
average execution price and the mid-quote at arrival, expressed in basis points, signed by the side of the
trade. Impact is measured from mid-quote at arrival to mid-quote at the time of the last fill, also signed
by the side of the trade. Close is the signed return from order arrival to the market close of the day the
trade was completed. Close + 1, 2, 5 and 10 days are the signed returns from arrival until the market
close on the next day and the next 2, 5 and 10 days after completion, respectively. The difference
between each return and the shortfall represents the mark-to-market P&L at the respective market
close. The results show that the P&L is always statistically significant and negative for cash flow trades,
whereas it becomes insignificant after 2 days for other trades.
In Table 2b the returns are beta-adjusted to remove the systematic component from market drift. We
define beta-adjusted shortfall as the shortfall minus one half of the stock's beta times the change in the
S&P500 index from the start to the end of the trade, signed by the side of the trade. The factor of one
half reflects the assumption that the execution takes place uniformly from the beginning to the end of
the trade and the market drift is linear over that period. For the beta-adjusted impact we subtract the

11
full S&P500 return from start to end of trading. Similarly, the beta-adjusted returns to each market close
subtract the full S&P500 return throughout the respective time window.
(returns)

Cash Flow trades

Return
Mean

Other Trades

Return-Shortfall
Mean

S.e.
---

Return
Mean

Return-Shortfall
Mean

33.24

S.e.

Shortfall

27.22

---

Impact

33.66

6.44*

(0.69)

44.95

11.71*

(0.44)

Close

21.01

-6.21*

(1.04)

40.65

7.41*

(0.6)

Close+1 Day

16.35

-10.87*

(1.79)

38.17

4.93*

(1.04)

Close+2 Days

13.9

-13.32*

(2.37)

32.96

-0.28

(1.28)

Close+5 Days

-4.99

-32.21*

(3.61)

33.19

-0.05

(1.88)

Close+10 Days

-9.33

-36.55*

(5.05)

35.51

2.27

(2.54)

Observations

27,591

87,658

()

Cash Flow trades

Other Trades

Return
Mean

Return-Shortfall
Mean

S.e.

Mean

Return-Shortfall
Mean

24.01

Impact

27.26

3.25*

(0.61)

48.18

13.33*

(0.40)

Close

15.35

-8.66*

(0.986

41.92

7.07*

(0.53)

Close+1 Day

10

-14.01*

(1.57)

38.16

3.31*

(0.9)

Close+2 Days

7.85

-16.16*

(2.04)

34.49

-0.36

(1.12)

Close+5 Days

0.89

-23.12*

(3.09)

32.22

-2.62

(1.56)

Close+10 Days

-13.43

-37.44*

(4.27)

33.02

-1.83

(2.09)

27,591

34.85

S.e.

Shortfall

Observations

---

Return

---

87,658

Table 2a, b: Average returns from arrival and average by trade purpose (bps). Shortfall, impact and returns to
the market close after the trade is completed are shown both in terms of absolute returns (top) and in terms of
beta-adjusted returns (bottom). Standard errors are in parenthesis. Results marked with * are statistically different

12
from 0 at a 5% significance level. The results show that cash flow trades are profitable for liquidity providers; for
the other trade (and the overall set) the results are consistent with breakeven on average.

The average beta-adjusted shortfall for cash flow trades is 24 basis points and the total impact at the
end of these trades is 27.3 bps. After the trade is finished, price reverts completely retracing the impact
by T+5. The other trades have an adjusted shortfall of 34.9 bps and a peak impact of 48.2 bps. Reversion
brings the adjusted return from arrival to 34.5 bps at T+2, within 0.4bps of the shortfall. Thus, with or
without beta adjustment, the post-reversion prices for all trades excluding cash flow trades at the
market close on T+2, T+5 and T+10 are not statistically different from the average execution price - i.e.,
these trades break even on average.
Breakeven on average should not be confused with fair pricing, which states that trades must break
even for every trade size - a much stronger condition. As explained in more detail in [FGLW], breakeven
averaged over all trade sizes follows from the assumption that liquidity providers are efficient: if
metaorders made money on average there would be no liquidity providers. If they lost a considerable
amount of money to liquidity providers these would compete more aggressively and in so doing drive
impact costs lower.
Our findings suggest that cash flow trades are profitable for the liquidity provider. At first glance this
would seem to violate market efficiency. However, when liquidity providers compete to interact with a
metaorder on the market, they have no way to know whether a trade is a cash flow trade or an
investment decision. If we blend results from cash flow trades and other trades, the value-weighted
average P&L of liquidity providers at T+2 is indistinguishable from zero at -0.19bps.
3.2 Fair Pricing
Efficient competition between liquidity providers implies that their profits should be vanishingly small
when averaged over all metaorder sizes. Does the same argument also enforce fair pricing? If liquidity
providers were able to know the size of a metaorder before providing liquidity, they would compete to
fill metaorders at the expected post-reversion price for the given size and competition would enforce
the fair pricing condition. But this is not how the markets work3: liquidity providers generally interact
with child orders sliced from a metaorder without knowing the parents true size. The liquidity provider

The exception would be cash desks, which quote a price for the entire trade. Even here, cash desks will generally
exit positions over time using algorithms so ultimately the fair price is that which can be realized through an
extended execution process in a continuous market.

13
must set a price for each slice without knowing whether it will be the last. Let's imagine for example that
providing liquidity to fill small metaorders were profitable. The average over all sizes breaks even, so it
would be rational for a liquidity provider to provide capital to fill the first slice, hoping to make a profit if
the metaorder is small. If the metaorder turns out to be large, the liquidity provider will come to realize
that providing liquidity early on was an unlucky choice, but the marginal capital commitment required to
continue from that point forward can still be economically rational. So the efficient competition of
liquidity providers doesn't provide a mechanism to avoid cross-subsidization across sizes: losses on large
trades and compensating profits on small ones. Efficient competition between liquidity providers
enforces that each slice is priced at the expected reversion price given the information at that point; this
guarantees breakeven on average but not for every trade size.
FGLW show that metaorders break even for every size when multiple investors compete to exploit a
shared information signal in a Nash equilibrium where the information is completely consumed by
market impact. Each portfolio manager does not know how much size the others will place and must
learn to find the optimal sizes through experience. If the aggregate size were consistently too large for a
certain type of information signal, investors would experience an average loss after reversion and
reduce their order sizes. Vice-versa if the aggregate size were systematically too small there would be a
mark-to-market profit and each investor would have an incentive to place a larger order. At the
equilibrium, the realized price to execute the entire trade is equal to the expected price after reversion.
In other words, implementation shortfall equals permanent impact for each metaorder size. This
property is called "fair pricing" because both the investor and the liquidity provider break even when
their positions are marked to market at the reversion price. FGLW argue that fair pricing must be
enforced by portfolio managers, since they are the ones who choose order sizes. Larger orders cause
more impact and, as our results on cash flows illustrate, if the impact is not matched by information this
results in mark-to-market AUM losses after reversion. So a portfolio manager would avoid placing a
large order when she has less confidence in the decision or expects other managers to overtrade the
same signal. The aggregated metaorders would then represent the portfolio managers collective vote
on the information of the signal. Fair pricing claims that this vote is accurate on average.
Before testing the fair pricing condition, we need a methodology for measuring the reversion price for
each order size. Figure 1 shows the beta-adjusted returns as a function of time grouped by trade
duration and purpose. For all trades excluding cash flow trades we find that trades that take longer to
execute also require a greater amount of time for reversion. Reversion is complete by the market close

14
for trades execute in a half day or less; for trades between 1/2 day and 2 days, reversion is complete at
the end of the second day after the close; for trades that require between 2 and 5 days to execute,
reversion continues for 5 days; for the largest trades which execute for more than 5 days, reversion also
takes at last 5 days to complete.
Figure 1 also shows that the shape and scale of market impact is similar during the execution of cash
flow trades as for informed trades. The shortfall and total impact at the end of cash flow trades is the
same as the average of other trades. After the trade is completed, the difference becomes clearly
apparent with cash flow trades post-reversion prices lower than the average execution price by the end
of the day of trade completion. By five days after trade completion, cash flow trades have experienced
full reversion, i.e. the impact has been completely erased and the realized shortfall stands as a mark-tomarket portfolio loss. This result is surprising since it suggests suboptimal trade sizes were chosen for
cash flow trades; there are potential savings from spreading liquidity trades across the assets in the
portfolio in such a manner that no individual cash trade is a large percentage of daily volume.
These results support the viewpoint adopted by zero and -intelligence models that during the
execution process the market is primarily concerned with digesting an order flow imbalance that looks
the same for cash flow trades as for other trades. But the observation of fair pricing for informed trades
once the process of reversion is completed and complete price reversion for uninformed trades give
strong support to the theory about the role of information on permanent market impact.
Beta-Adjusted Returns vs Time by Trade Duration and Purpose
160

Return vs Trade Arrival [bps]

140
120
100
80
60
40
20
0
-20

Start Average End

Close 1 Day 2 Days

5 Days

10 Days

-40
< 1/2 day

1/2 to 2 days

2-5 days

5+ days

Cash Trades

15
Figure 1: Beta-adjusted returns) from arrival by trade duration and purpose. Reversion time takes the same
number of days to complete as the duration of the metaorder. The average shortfall and end impact of cash flow
trades are similar to the average for non-cash-flow trades, but the returns after trade completion are markedly
different. Cash flow trades revert completely, whereas each other group only reverts back to a level similar to the
shortfall (first point from the left), consistent with the fair pricing concept.

In Table 3, we provide a more formal testing of the fair pricing condition for the four duration bins for
all trades excluding cash flow trades, over a longer time scale up to 60 trading days from order
completion. The results show that for the smallest trades fair pricing that equates average execution
price and post-reversion price cannot be rejected at the next day market close. For trades that take at
least half a day to complete we cant reject the null of fair pricing at the close on t+2 or higher. For
trades longer than 2 days returns to t+5 still exceed the shortfall by more than 7 basis points but this
difference is not statistically significant due to the smaller sample size and larger standard error.
Similarly, for trades longer than 5 days returns to T+2 and T+5 exceed shortfall by 18.4 and 8.3 bps,
respectively, but the differences are not statistically significant. Our results on reversion support fair
pricing for all trade durations, but we also cannot reject the -intelligence prediction of 25% reversion.

16

<0.5 Days
Return
Mean
Shortfall

22.72

Impact

30.43

Close

20.53

+1 Day

21.39

+2 Days

20.38

+5 Days

18.08

+10 Days

18.65

+20 Days

19.36

+60 Days

18.73

ReturnShortfall
Mean
(s.e.)

0.5-2 Days
Return
Mean

ReturnShortfall
Mean
(S.e.)

37.73
7.71*
(0.4)

(0.66)

(1.21)

(1.56)

(2.13)

(2.85)

-3.36
(4.51)

(4.15)

Obs

34,384

(3.19)

(7.34)
45,393

50.21*
143.75

(7.91)
37.09*

130.63

(9.56)

13.25*
79.58

(4.6)

34.04*
127.58

(10.7)

7.93
74.26

(4.9)

18.78
112.32

(11.8)

1.83
68.16

(6.75)

10.43
103.97

(15.4)

3.61
69.94

(9.12)

-0.37
93.17

(18.4)

1.66
67.99

(11.8)

-4.6
33.13

Mean

ReturnShortfall
Mean
(s.e.)

19.63*
85.96

3.15
40.88

-3.99
(7.99)

(2.65)

-1.67
36.06

Return

29.34*
95.67

-2.14
35.59

-4.07
(3.32)

(0.56)

5+ Days

93.54

-1.08
36.65

-4.64
(2.35)

ReturnShortfall
Mean
(s.e.)

66.33

4.03*
41.761

-2.34
(1.68)

Mean

11.19*
48.92

-1.33
(1.37)

Return

14.15*
51.88

-2.19*
(0.75)

2-5 Days

-23.75
69.79

(25.3)

1.09
67.42

(19.2)
6,456

1.86
95.40

(44.5)
1,425

Table 3: Beta-adjusted shortfall, impact and returns to market close (bps). The fair pricing condition cannot be
rejected after a reversion time equal to the maximum trade duration in each duration bin. Bootstrapped standard
errors are in parentheses. Results market with * are statistically different from 0 at 5% significance level.

Figure 2 shows the average beta-adjusted returns from arrival for all trades excluding cash flow trades,
grouped by trade difficulty which is measured as the estimated impact as defined in (1). We compare
average beta-adjusted shortfall to the beta-adjusted returns from arrival up to the end of the reversion
time as suggested in table 3. For trades shorter than a half day we take the next day close as the
relevant post-reversion benchmark. For trades with execution times between half a day and two trading
days we take the market close at the end of the second day after the last fill. For trades between 2 and 5
days long and more the 5 days long we take, respectively, the market close at t+5 and t+10. The results

17
show that fair pricing holds consistently across all ranges of trade difficulty since there are no significant
differences between the average shortfall and the returns to the reversion price.

Breakeven vs Relative Trade Size - Excluding Cash Trades

180
160
140

45

Return vs Arrival [bps]

120
100
80
60
40
20
0
-20

20

40

60

80

100

120

140

E(impact)
Beta-Adjusted Shortfall

Beta-Adjusted Reversion Price

Figure 2: Fair pricing. We show beta-adjusted returns from arrival by trade difficulty for all trades excluding cash
flow trades. The fair pricing assumption is verified for each trade difficulty: the beta-adjusted implementation
shortfall (blue line) matches permanent impact as measured by the signed beta-adjusted returns to the reversion
price. The fine dashed line diagonal represents the expected shortfall according to model (1). Error bars are
bootstrapped standard errors of the difference between adjusted shortfall and post-reversion returns.

Our results on fair pricing above relied on bootstrapped standard errors to avoid relying on the Gaussian
assumption which can underestimate uncertainty in financial data due to tail effects. But even
bootstrapped standard errors can underestimate uncertainty due to the heterogeneity in stocks or the
presence of persistent market modes. For example, markets can exhibit persistent structure over an
extended bull market or in a persistent range-bound market. To address these issues, in Appendix A we
include analyses by quarter, trade size and liquidity. The results show that trades break even on a betaadjusted basis still holds separately for every data subgroup.

18
As mentioned previously, our empirical analysis was based on post-trade returns adjusted for the impact
of subsequent trades by the same firm in the same stock that occur with a gap greater than 60 minutes
for different portfolio managers, or after at least a full day pause for the same manager. We believe this
removal to be appropriate to remove a bias where portfolio managers are more likely to buy stocks that
have come down further, or add to sales in stocks that have continued to rise. To assess the effect of the
post-trade impact adjustment on our findings, we show in Figure 2b the results on fair pricing without
impact adjustments. There is an apparent profit that can be explained by the impact of continuing
trades in the same direction. Continuing trades are more common than reversals (selling a stock that the
firm recently bought) and are more likely to occur following price improvement.

Breakeven vs Relative Trade Size - Excluding Cash Trades

180
160
140

45

Return vs Arrival [bps]

120
100
80
60
40
20
0
-20

20

40

60

E(impact)

Beta-Adjusted Shortfall

80

100

120

140

Beta-Adjusted Reversion Price

Figure 2b. Fair pricing without impact adjustments. Figure 2 is reproduced using prices without
adjusting for the impact of subsequent trades by the same firm in the same stock. Large metaorders
appear to have a positive P&L of 10-30bps on average after reversion due to follow-on trades in the
same direction.

4. Deviations from Fair Pricing

FGLW derives the fair pricing condition from a Nash equilibrium in the competition between portfolio
managers who are responding to a shared information signal. If this competitive equilibrium causes the

19
equivalence between shortfall and permanent impact that is observed in the above figures, then the
argument clearly should not apply to cash flow trades. So there would be no reason to believe that fair
pricing should hold in that case, and indeed as we have seen it does not. In Figure 3 we illustrate the
failure of fair pricing for cash flows as a function of trade difficulty. The impact of cash flow trades tends
to revert completely for all trades except those in the range between 30 and 60 bps of trade difficulty.
Even for these trades, reversion more than compensates for average shortfall by a large extent so we
can conclude cash flow trades have little to no permanent impact on average. This chart is essentially
the same if one doesnt adjust for the impact of continuing trades.

Breakeven vs Relative Trade Size - Cash Trades

120

Return vs Arrival [bps]

80
40
0
0

20

40

60

80

100

120

-40
-80
-120

E(impact)
Beta-Adjusted Shortfall

Beta-Adjusted Reversion Price

Figure 3: Returns from arrival by trade difficulty for cash flow trades. The impact of cash flow trades reverts
completely for trade difficulties below 20bps and above 70bps; for intermediate trade difficulties approximately
half of the implementation shortfall is lost after reversion. The dashed diagonal line is the expected shortfall
according to model (1). Error bars are bootstrapped standard errors of the difference between adjusted shortfall
and post-reversion returns.

To explore the fair pricing condition in more detail, in Table 4 we describe how order and stock
characteristics are associated with variations in the unrealized beta-adjusted P&L of the liquidity
providers at the time reversion is complete. The beta-adjusted P/(L) is measured as the difference
between the beta-adjusted shortfall and beta-adjusted return from arrival to the reversion price.
Consistently with our analysis in the previous section, we set the reversion price as the T+1 close for

20
trades that take up to half a day to execute, T+2 close for trades that require between half a day and
two days to complete, T+5 close for trades that take more than two days but no more than five days,
and T+10 close for the largest trades. The set of regressors includes the square root of size relative to
ADV, volatility and spread, the beta-adjusted momentum from the prior 5 days and between the market
open and order arrival. We also include indicator variables for trades in stocks of large and small market
capitalization, buy orders, Nasdaq stocks and the cases where the trade was aggregated across multiple
portfolio managers sharing the same trading desk. The coefficient estimates with respect to each
regressor represent its impact on the P/(L) after adjusting for all other variables: a positive value means
that the variable is associated with a higher P/(L) for liquidity providers, whereas a negative value
implies a lower P/(L) on average.
The regression for cash flow trades shows that larger gains are associated with larger trade sizes,
reflecting stronger reversion for these orders.
Except for cash flow trades, trade size is not a significant determinant of deviations from fair pricing.
Trades with multiple portfolio managers are more likely to be associated with a negative P/(L) for the
liquidity provider. While our data doesn't disclose the specific mechanism that would result in multiple
portfolio managers building or unwinding positions concurrently, we know from portfolio managers that
some signals are originated from the firm's own analysts and shared with all portfolio managers whereas
other orders will represent the views of an individual manager. Yet another type of trade origination is a
response to third party research reports. In these cases the trades are most likely to be
contemporaneous with trades from portfolio managers at other firms, which would imply that the
aggregate metaorder size counting all firms would be larger than what is observed here.
Our results also show that Nasdaq remains a significant negative factor of the mark-to-market P&L of
liquidity providers even after controlling for size. Similar results have been found in numerous studies
(see Bessembinder, 1999; Huang and Stoll, 1996; Chan and Lakonishok, 1997; Conrad et al. 2003;
Obizhaeva, 2007) This could be explained by the fact that NYSE specialists operate in centralized
markets and are better informed about current situation in their stocks, corroborating the theory that
information reflects on permanent market impact
Prior momentum is a positive driver of the liquidity provider P/(L), possibly representing a continuation
of an aggregate metaorder that started with other firms not included within our dataset. In this case, it
is possible that the later arrival in our dataset takes a loss after reversion while the P/(L) on the

21
aggregate metaorder is zero , since in metaorders that aggregate interests from multiple firms, the first
firms to respond to a signal make a mark-to-market profit while the last ones to join into the trade will
incur a loss.
Beta-adjusted P/(L) (Shortfall - Permanent Impact)
Cash

Others

Coefficient

S.E

Coefficient

S.E.

Sqrt(Size)

71.69*

(36.1)

4.47

(8.59)

Volatility

0.33

(0.17)

-0.03

(0.12)

Spread

-0.05

(0.06)

0.00

(0.07)

Large Cap

-6.5

(5.88)

8.57*

(3.77)

Mid Cap

-7.19

(4.38)

4.89

(3.27)

Buy Order

-3.24

(3.46)

-2.75

(2.18)

Multiple PM

-2.81

(5.05)

-12.98*

(2.61)

Nasdaq

0.3

(4.08)

-9.98*

(2.97)

New Trade

-7.08

(5.04)

-8.18*

(3.09)

Price Improve

1.75

(5.11)

7.43*

(2.99)

Take Profit

-14.89*

(6.52)

-4.51

(3.8)

Stop Loss

-12.37*

(6.1)

0.93

(4.17)

Momentum

-0.00

(0.02)

.15*

(0.02)

Constant

-0.73

(10.5)

5.61

(6.21)

R2

0.002

0.009

27,591

87,658

Table 4: Regression analysis for the beta-adjusted P&L of liquidity providers. Bootstapped standard errors in
parentheses. Trades aggregated across multiple portfolio managers, new trades and trades in Nasdaq-listed names
are significant positive drivers of mark-to-market P&L at the final reversion price, reflecting the fact that these
trades are more likely to be more informed than average leaving a profit for the portfolio manager. Vice-versa, the
liquidity provider is more likely to make a profit in trades that seek to improve the portfolio manager's average
price by adding to a prior decision, trades in large cap stocks, and trades that follow prior momentum.

The regression includes trade origination type, defined by comparing the metaorder with prior orders by
the same firm within the last three months. New trades are cases where there was no prior metaorder

22
from the same portfolio manager within the last 3 months; profit taking trades are reversals of prior
decisions at a profitable price, whereas price improvement trades are trades that add to a prior decision
at lower price for a buy, or higher price for a sell. The remaining cases are collinear. The results in Table
4 show that price improvement trades are more profitable for the liquidity provider. New trades and
profit-taking trades tend to be profitable for the portfolio manager although the latter is not significant.
Price-improving trades are profitable for the liquidity provider. Volatility, market capitalization and side
of the trade are also not significant predictors of deviations from fair pricing.
In Figure 4 we consider fair pricing by portfolio manager. We label metaorders that aggregate several
orders with the portfolio manager that placed the first order in the aggregate, then take the 20 portfolio
managers that appear most frequently. There are a few significant deviations from fair pricing. At the
right of the figure a small-cap portfolio manager has higher-than-average shortfalls and even higher
permanent impact. The lowest shortfall at the left of the chart corresponds to a manager with an
average negative mark-to-market P&L. Upon further investigation we found that that the desk executes
these orders with limits and the residuals are dropped at the end of the trading day as the portfolio is
re-optimized daily. The orders that only filled a small number of shares due to the limits and strong
short-term information were dropped due to our size filter.

Breakeven by Portfolio Manager

120
100

Bps

80
60
40
20
0
1

10

11

12

13

14

15

16

17

-20
Beta-Adjusted Shortfall

Beta-Adjusted Reversion Price

Figure 4. Breakeven by portfolio manager shows few deviations from fair pricing.

18

19

20

23

5. Comparing Predictions of Fair Pricing and Epsilon Intelligence Models

The fair pricing and the -intelligence models both capture realistic properties of the market, but they
are conceptually very different.
The fair pricing theory predicts the shape of the impact function using a no arbitrage argument. Liquidity
providers set the price at each step to the expected price considering two possible scenarios: in one
scenario the metaorder ends and the liquidity provider will earn a return equal to the amount of
reversion; in the other scenario the metaorder continues and the liquidity provider will face a mark-tomarket loss. The efficient market price is such that the expected return averaging over these two
scenarios is equal to zero. The continuation probability is derived from the distribution of metaorder
sizes. Thus the basic mechanism for pricing impact according to FGLW is quote setting by liquidity
providers trying to predict when a hidden order will end in order to take advantage of the reversion, or
vice-versa, ride along with the trend if they believe it will continue. Unfortunately, the shape of the
impact function in fair pricing theory is sensitive to the tail behavior of the order size distribution, which
is difficult to observe with precision. The order size distribution has been reported to have a Pareto
exponent = 1.5 in which case FGLW show that the impact function is a square root of trade size. In
Appendix B, we study the distribution of trade sizes in our sample, our results are consistent with a tail
exponent 1.5, but we cannot exclude the log-normal hypothesis, which leads to a very different shape
for the impact function (Farmer et al. 2013). The no arbitrage argument in fair pricing theory requires
market makers to be very intelligent indeed since they must balance the metaorder continuation or
ending probabilities with expected returns in two possible outcomes. If impact is priced using such
intelligent arbitrageurs one might wonder why they are not able to form expectations about trade
intention (cash flow trade or informed trade) until after the execution has ended?
The -intelligence model makes far less demanding assumptions on market makers behavior. In
particular, it does not require market participants to know the tail behavior of the order size
distribution. Since the impact of cash flow trades is very similar to that of other trades during the
execution process we could surmise that impact should be primarily a mechanical process resulting from
the bias in a flow of mostly-random orders into a double auction market. The -intelligence model
assumes that the book that is populated by a stream of orders that are priced relative to the current
midpoint, which persist until they are canceled or filled. The new market midpoint price is immediately

24
accepted by market participants as a reference price relative to which new orders should be priced.
Market orders consume part or all of the inside quote causing a V-shaped liquidity profile near the
current price. For fast execution rates this implies a square root impact function (Bouchaud et al. 2004).
Parameters control the relative rates of limit order and market order arrivals, and the relative rates of
cancellations to limit order arrivals. Toth et al. (2011) find that if market order sizes are independent of
the quote size the system is sub-diffusive, implying systematic profits for market makers. Vice-versa, if
incoming market orders are sized to consume the entire quote the system is super-diffusive; Toth et al.
propose a distribution of the fraction of the opposing quote that will be consumed by incoming
orders, = 1

. The limit = 1 corresponds to a flat distribution for the fraction of eaten

volume whereas for we have unit volumes. The diffusive regime which is consistent with
efficiency corresponds to = 0.95.
Is the real world driven by the collective intelligence of competing market makers enforcing efficiency
and competing portfolio managers enforcing fair pricing? Or, is it driven by a stochastic process of
almost-random orders interacting in a double-auction market which organizes itself at a critical point
where prices are diffusive?
At first glance, it seems to be a coincidence that the two points of view yield similar results for impact
during the execution: both predict concave impact functions with exponents close to 1/2. If the
metaorder size distribution had a different tail exponent, the -intelligence model would still predict the
same shape for the impact function but the FGLW model would predict a different exponent. A possible
explanation might be that impact is primarily mechanical as described in the -intelligence model and
portfolio managers in the process of enforcing fair pricing set the metaorder size distribution to have a
tail exponent of 1.5. We will develop this idea in more detail in the discussion.
In this section we will explore whether our data enables us to pick apart the predictions of -intelligence
model and fair pricing theory with respect to market impact.
5.1 Impact Scaling Exponent
Fair pricing theory predicts a concave shape for the impact function with an exponent one less than the
tail exponent of the order size distribution. For the exponent reported in the literature this corresponds
to a square root impact function. In the -intelligence model the shape of the impact function depends
on parameters that calibrate the relative effect of limit order arrivals that repopulate the order book

25
and market orders which tend to deplete it. For realistic values of the parameters, impact is predicted to
scale as a power between 0.55 and 0.65 of the trade size.
Our data involves a wide array of US traded stocks with varying spreads, trading volumes and volatilities;
since trading size is correlated to these other variables a univariate regression would produce a biased
estimate of the size exponent. In order to test the scaling exponent with some accuracy we need to
capture the functional form of the impacts dependency on all relevant factors.
Implementation shortfall is usually modeled as the sum of a spread term and a market impact term. To
determine the spread coefficient we bin the data by spread and in each bin measure the spread term as
the y-intercept of shortfall versus trade difficulty; a plot of the y-intercept as a function of the spread
reveals a slope of 0.25. We model the impact term as proportional to contemporaneous volatility and a
power of trade size relative to current daily volume. Contemporaneous volatility is scaled to an
annualized % value, = 100

390252

, where is the trade duration in minutes and where

we have taken the US trading day duration of 390 minutes and assumed 252 trading days per year. We
set upper and lower bounds on the contemporaneous volatility at 1/5 and 5x the 60-day trailing daily
volatility measure, also scaled to an annual value. Contemporaneous volume is scaled to a daily value.
For simplicity's sake, we flatten the volume smile and simply estimate daily volume as =
390
),

where is the elapsed market volume in the security during the execution of the

metaorder. With these choices we have a preliminary model of shortfall as 0 =

1

The exponent was estimated in three bins by $ADV, from 0 to $5m, $5-50m and greater than $50m.
The corresponding results of {0.48, 0.51, 0.46} are consistent with the common square root assumption,
so we adopted = 0.5 for the preliminary model. In Figure 5 we plot the actual shortfall and
0 from the preliminary calibrated model, both net of the spread term, as a function of the
stock's daily traded value in currency, $ADV. This representation illustrates a systematic error term from
the preliminary model suggesting impact dependency on daily traded value. To reduce this error term,
we model the scaling factor as a monotonously increasing function of the stock's traded volume in
currency. Altogether:

26

Shortfall and Preliminary Model vs $ADV

100
90
80
70

bps

60
50

E_0(shortfall)

40

shortfall

30
20
10
0
0.1

10

100

1000

10000

$ADV[m]
Figure 5: Impact dependency on daily traded value. The conventional form of market impact as proportional to
the product of volatility and square root of relative size underestimates the impact of highliquidity names and
overestimates the impact of small caps.
1

= 4 + $

(3)

where
= 1.25 + 0.55 (1 + 0.6 [$])

(4)

The model (3-4) predicts the shortfall with 2 = 10.3%, as compared to 2 = 6.9% for the simpler
model given in Equation (1) (or 5.7% without beta-adjustment). Since (1) was used to adjust reversion
prices for the impact of continuation trades, we decided to test the robusteness of our results to the
impact model by doing the same analysis using instead model (3-4). We found that impact does not
substantially change any of the results. However, as we explain next, a correct accounting of the effect
of market capitalization on impact is important to measure the size exponent . Trade execution data is
often heterogeneous, with small-cap stocks more common for large trades relative to daily volume
whereas large-cap stocks are more common in trades that represent a smaller fraction of daily volume.
When drawing a plot of implementation shortfall as a function of relative trade size, the left part of the
chart represents predominantly the impact of large cap stocks whereas the right part is more
representative of the impact of small caps. This can lead to an incorrect estimate of the size exponent.

27
For example, if market impact were linear but with a smaller slope for small-cap stocks than large caps,
the impact chart would appear to be concave. The impact scaling factor (4) controls for the effect of
market capitalization on the scale of market impact.
The scaling of impact with a stock's market capitalization (closely related to daily traded value) was also
studied by Lillo, Farmer and Mantegna (Lillo et al, 2003) who found a concave function for singletransaction impacts with exponent 0.3. The aggregate impact of a metaorder logically inherits the
concavity of the single-transaction impact as a function of market capitalization, albeit not necessarily
with the same exponent: the impact of a metaorder combines the effects of single-transaction impact
and its decay over time. In (4) we used the total traded volume instead of market capitalization and
found that for metaorders a logarithmic function provides a better fit to the dependency of impact on
volume than a power law. When we fit a power law we find an exponent of 0.15, half of the value of 0.3
presented in Lillo et al.. In our sample their model overestimates the impact of metaorders in high
volume stocks by a factor of 2. Unlike a power law, the log model (4) allows for non-zero impact in the
limit of very illiquid securities, which we believe is more realistic.
With these choices, model calibration again yields = 0.5. Statistical testing rejects the higher
exponent predicted by the -intelligence model (0.55-0.65 for the participation rates prevailing in our
sample). We note however that the estimation of the size exponent could be affected by selection bias
preventing the realization of large shortfalls for larger trades.
5.2 Shape of the Impact Function
We define a form factor as the ratio of peak impact at the end of the trade to the average impact. From
1

(3): 4 = $ , where is the trade size normalized to daily volume.

The ratio of peak impact to average impact is =

1
0

= + 1.

The -intelligence model predicts that the average impact paid for the hidden order is 0.6 times the
peak impact, i.e. = 1.67. The fair pricing model predicts a square root impact function and = 1.5. To
test the two models, we estimate separately the slopes of the end impact and average impact (shortfall)
as a function of estimated impact, defined as the second term in the right-hand-side of (3). The estimate
1.685

for the overall ratio of the slopes is the form factor = 1.139 = 1.48.

28
We considered the form factor separately for cash flow trades and other trades, and for buys vs sells.
Figure 6 illustrates the ratio of slopes in the case of buys not marked as cash flows and Figure 7 shows
the form factor by trade intention and side. We find a lower form factor (greater concavity of the impact
function) for cash flow trades and for sells. For non-cash flow sells, the shortfall and impact are initially
similar to buys, but shortfall levels off at 120 bps and impact at 175bps. We speculate that this could be
due to limits intended to protect the value of the portfolio by not forcing the sale of stocks in absence of
willing buyers, since this would reduce the value of the residual position.

Actual vs Estimated Impact

Buys excluding cash flow trades
Shortfall - 1/4 spread [bps]

350
300
250

y = 1.8372x

200
150

y = 1.1903x

100
50
0
0

20

40

60

80

100

120

140

160

180

Estimated Impact

Figure 6: Estimating the form factor for the impact function. We estimate the form factor as the ratio of slopes of
total impact (squares) to the shortfall (X's) as a function of estimated impact for buy trades that are not marked as
cash flows. The ratio of the slopes is 1.54, consistent with the prediction of fair pricing theory.

29

Form Factor by Trade Type

1.6
1.55
1.5
1.45
1.4
1.35
1.3
1.25
1.2
1.15
1.1
cash sells

cash buys

other sells

other buys

Figure 7. Form factor for cash flow and other trades, by trade sign. The ratio between peak impact and
implementation shortfall is 1.29 for cash flow trades. For other trades we cannot exclude the fair pricing theory
prediction of 1.5. The prediction of a form factor of 1.67 in the -intelligence model is rejected.

In Figure 8 we explore the shape of the impact function more directly by showing the end impact as a
function of estimated impact as defined in (3). The end impact of cash flow trades is statistically
indistinguishable from that of other trades and both are indistinguishable from 1.5 times the estimated
average impact.

Shape of Impact Function

cash flows vs other trades
350

End impact [bps]

300
250

200
Excluding cash
150

Cash flows

100

(1.5 x estimated)

50

0
0

50

100

150

Estimated impact [bps]

200

30
Figure 8: Shape of market impact for cash flows and other trades. We show peak impact as a function of
estimated impact for cash flow trades and other trades, using beta-adjusted returns from start to end of trading,
signed by the side of the trade. The two types of trades have similar impacts: the peak impact of cash flow trades is
slightly less for estimated impacts between 50bps and 120bps but the difference is not statistically significant. We
cannot reject the hypothesis that peak impact is 1.5 times the estimated average impact for either type of trade.

5.3 Relation between market impact and information

The -intelligence model predicts that impact and reversion occur from the dynamics of order flow
independently of considerations regarding the information that may have led to the creation of an
order; this does not preclude that orders carry information on average, but it shows that impact and
reversion are primarily mechanical processes whereas information more likely reveals itself on a much
longer timescale comparable with the investment horizon. Fair pricing theory describes market impact
as the process of estimating the value of short-term information that triggered a trade knowing only the
size of the order. If impact reveals the information content of trades, it would be natural to expect a
lower impact scaling coefficient for cash flow trades than for other trades. The slopes of the lines shown
in Figure 8 show that the impact coefficient is not significantly lower for cash flow trades. The form
factor is slightly less as illustrated previously in Figure 7 is slightly lower for cash trades, reflecting
perhaps that in some cases the market may begin to realize near the end of the trade that it is dealing
with a cash flow trade. The finding that impact scaling factor is the same for cash flow trades suggests
that mechanical effects resulting from the imbalance in order flow dominate the process while the trade
is executing. Given that only 25% of the metaorders are cash flows (recall of are only considering size
above 1% ADV) and an order flow imbalance is more readily observable than information, a Bayesian
market maker will price impact assuming that the trade is most likely informed. We can make this point
more precisely as follows. In absence of an informed institutional trade the expected return would be
small due to efficiency. Therefore, the expected return is
, + (1 , ,
We use a vector to represent information sources that would typically be inputs to a relative valuation
model. Once the trade is completed, an initial reversion process accounts for the fact that the order flow
imbalance has stopped. As explained in FGLW, if we assume efficient pricing, this first reversion step
( )

produces a return = 1(

+ where + is the expected return conditional on the

order continuing and is the probability that it will continue. After this initial reversion

31
process, expected returns are driven by an equation as above but in absence of an order flow imbalance
the first term on the right-hand-side vanishes and prices are now driven by the smaller second term, as
= . If the trade was uninformed, relative valuation models will provide a recall force
through (|) driving continuing reversion for cash flow trades. It seems unlikely that any individual
valuation model would be sufficiently precise to drive complete reversion after cash flows however,
the market averages the outputs of a large number of relative valuation models designed by different
quantitative analysts across the industry. If the model errors are random and uncorrelated the error on
the average of N models falls off as 1/ . The evidence suggests that collectively this apparatus may be
able to discern the fair price accurately enough to completely erase the impact of cash flow trades.
6.4 Reversion
The amount of reversion in the -intelligence model depends on the order flow autocorrelation
exponent . For cash equities, = 0.5 and reversion should represent 1/4 of peak impact. Fair pricing

theory predicts a reversion of +1 = 1/3 for = 0.5. Based on the reversion results shown in Table 3,
our findings cannot reject either model.

6. Discussion
We empirically studied the market impact of metaorders that aggregate near-overlapping interests from
portfolio managers by asset management firm, security and side. We found that the post-trade
reversion process takes place over the same amount of time as the time used to execute the trade. Cash
flow trades revert completely over this timeframe, confirming the view that permanent impact is a
measure of the information content of a trade. For other trades we find that permanent impact equals
the implementation shortfall for every metaorder size, confirming the main prediction of fair pricing
theory.
Fair pricing asserts that portfolio managers collectively set order sizes such that their implementation
shortfall matches information. Given better information, either portfolio managers place larger orders
or a greater number of portfolio managers contribute to the metaorder size, or both. The prediction
power of trade size regarding the information content of the order is remarkable given that individual
portfolio managers work with very limited knowledge of the relative value of the signals they use to
trade. The fair pricing property appears to be an example of the ability of a large ensemble of weakly

32
informed agents to collectively arrive at an accurate answer through averaging, which is illustrated
through many other surprising examples in Surowiecki's bestseller "The Wisdom of The Crowds".
During the execution process itself, we find that the market hardly distinguishes between cash flow
trades and other trades, at least initially; this explains the success of mechanical models of market
impact such as the -intelligence model at reproducing many of the observed properties of market
impact, including its concave shape and price reversion. Farmer and Zamani (2007) introduce a
definition of mechanical impact which allows them to decompose impact into its mechanical and
informational components. They find that the two components are in general positively correlated but
behave very differently. In this model, mechanical impact is immediate and decays to zero
monotonically in time as a power law of about 1.7. Informational impact grows with time and
approaches a constant value asymptotically. As stated in Bouchaud et al. (2004), "Since trading on
modern electronic markets is anonymous, there cannot be any obvious difference between 'informed'
trades and 'uninformed' trades. Hence, the impact of any trade must statistically be the same, whether
informed or not informed. Impact is necessary for private information to be reflected in prices, but by
the same token, random fluctuations in order flow must necessarily contribute to the volatility of
markets." This reasoning is, to some extent, consistent with the observation that the difference
between cash flows and other trades becomes much more pronounced only after the trade is
completed. But the complete reversion of market impact for cash flow trades also implies that
permanent impact cannot be modeled in isolation of information - a portfolio manager cannot
permanently increase the price of a stock simply by buying it; the effect would dissipate after a few
days. So while we find that permanent impact is a square root of trade size, this should not be
misunderstood as a prediction that a random uninformed trade would cause permanent impact to be a
square root of trade size - for a random trade the permanent impact would be zero. It would be more
accurate to say that non-cash flow metaorder sizes scale as the square of permanent impact. The
absence of permanent impact for cash flow trades brings into question the no price manipulation
argument for the linearity of the permanent impact function (Huberman and Stanzl, 2004). Uninformed
trades cannot permanently alter prices. Price manipulation trades by design are uninformed, so they
have no permanent impact and hence cannot be used to manipulate prices. Our results are consistent
with the no dynamic arbitrage principle (Gatheral, J. 2010) since we show that prices ultimately are
unaffected by uninformed trading; round-trip trading costs for uninformed trades are positive due to
mechanical impact.

33
Not surprisingly, our results reject the informed trader model which predicts linear impact and no
reversion. Indeed, most institutional trades are not insider trades: the typical institutional trade is
created from information that is shared with others due to widely available sell-side analyst research
equal access to company news, policy changes, etc.
We considered the mark-to-market P&L of metaorders at the reversion price, conditioned on variables
correlated with information available to portfolio managers. If permanent impact were purely
mechanical, fair pricing would result in the P&L being null regardless of the type of trade. Instead, we
find classes of institutional trades that drive systematic AUM gains while others cause systematic losses
after reversion. Trades in Nasdaq listed names and new trades in stocks where the portfolio manager
has not been active in the last 3 months tend to be profitable after reversion, whereas portfolio
managers tend to over-estimate their information in price-improvement trades, trades in large-cap
stocks and trades initiated after strong intraday momentum. Trades merged from multiple portfolio
managers are more likely to be informed and have a positive mark-to-market P&L after reversion. Cash
trades are associated with a negative P&L.
The existing literature finds a tail exponent for the cumulative distribution of information shocks close to
3 (see for example Liu et al. 1999, Plerou et al. 1999). Given a square root impact function this would
imply that fair pricing requires the exponent of the trade size distribution to be 1.5 (Farmer et al. 2013).
Due to order splitting such a metaorder size distribution would cause order flow to have a long memory
with an autocorrelation function falling off as

1
.

Both the metaorder size distribution and the

autocorrelation exponent have been validated empirically in prior works (Lillo et al. 2005, Gabaix et al,
2006, Vaglica et al. 2008). If the institutional order sizes are rooted in information, the relationship
between "excess volatility" and institutional trades described by Gabaix et al. would be correct but best
laid out in the opposite order: it is not institutional trades that cause heavy-tailed returns, but a heavy
tail in information shocks that cause large institutional orders.
This requirement of the trade size distribution to be 1.5 may play a role in explaining the parameters in
the -intelligence model. Were the parameters set differently, there would be opportunities for market
makers and statistical arbitrageurs to make a profit if they are able to understand the statistics of the
game. In exploiting this opportunity, they would generate orders which would add to the random order
flows described in the -intelligence model. These new order flows could be modeled as a
renormalization of the parameters describing the order flows in the -intelligence model. It would be

34
interesting to explore whether such a renormalization argument can yield a fixed point (equilibrium)
where short-term opportunities are vanishingly small. In this equilibrium, the parameters of the
mechanical impact model must be such that price satisfies the efficiency condition in fair pricing theory.
A view of the market emerges as the mechanism that processes information shocks by translating them
into metaorders which in turn cause price changes through f market impact. News and research reports
generate a source of trading signals. The signals are received by portfolio managers who place orders
that get are aggregated into larger metaorders. The metaorders are executed over time using algorithms
and the shares are allocated back to portfolio managers at an average price. The competition between
portfolio managers leads them to place order sizes that in aggregate completely consume the
information resource, i.e. the average market impact cost paid to execute the metaorder is equal to the
permanent impact and the mark-to-market P&L on the trades is zero. Liquidity trading from cash flow
needs and from the second leg of round trip trades cause net AUM losses, explaining why most actively
managed funds underperform their benchmark.
Our results are consistent with the findings of other authors. Long reversion times have also been
observed in previous empirical studies in single trades that observe reversion up to the next trading day
(Biais et al, 1995, BGPW). Aggregated trades are larger trades and hence require a longer time for
reversion (Chan and Lakonishok 1995, 1997), (Moro et al. 2009), (Moro et al. and Bershova and Rakhlin
2013) also find that permanent impact is not significantly different from the implementation shortfall
and 2/3 of peak impact.
While fair pricing at first glance seems harmless to portfolio managers since mark-to-market P&L is zero
on average, in reality one should consider liquidation values instead of the mark-to-market values of
positions. In a round trip trade, the implementation shortfall on the sale is a net loss to assets under
management. Since it would be illogical for portfolio managers to trade in such way, we have to assume
that losses associated with apparent excess volume may be compensated by a closer relationship with
brokers which provide longer-term insights and that trading activity is to some extent related to longerterm information and goals.
Our conclusions shed light on sunshine trading: the idea of pre-announcing trades to minimize impact by
making clear that the trade is not motivated by short-term information. We find that the scale of market
impact during the execution is not significantly different for cash flow trades as for other trades.
However, impact appears to be more concave late in the trade for cash flow trades and for sell orders

35
which tend to be less informed. These observations suggest that the impact process during the
execution is initially dominated by mechanical effects, but once the trade continues, the market has the
opportunity to assess the likelihood that a trade is informed and provides liquidity at more favorable
prices. This implies that it should be possible to reduce costs of cash flow trades by pre-announcing
them. There are some practical difficulties in the way of deploying this idea in the existing market
structure, including the fact that cash flows often have little timing discretion, the regulatory issues
regarding the perception of "pre-arranging" trades and the need for some verification mechanism to
ensure that the announced trade is truly uninformed. To some extent, the market has already
implemented sunshine trading practices in the repeated game of cash desk relationships. Cash desks
offer several services where individual orders or lists are executed as a block against the dealer's capital.
Blind bids for baskets are qualified in terms of risk and sometimes absence of information; individual
orders are described as being cash flow trades to obtain better bids. In these examples, mislabeling of
trades by the buyside desk results in losses to the dealer and profits for the institution, but also damages
the relationship and the buyside trader's reputation.
Our results lend support to the Nash equilibrium argument proposed by FGLW to explain how portfolio
managers collectively set trade sizes that break even after reversion. Metaorders aggregate orders
placed by individual investors or portfolio managers who know they share the same information but do
not know the size placed by others. If an individual manager expects that the gain generated by this
information is likely to exceed the implementation shortfall, she will have an incentive to increase the
size of her order. Vice-versa, if a negative P&L is expected, she will reduce her order size. The fair pricing
equilibrium is reminiscent of the tragedy of the commons (Hardin, 1968), in the sense that the value of
information signals to the portfolio manager community is destroyed through overtrading. The Nash
equilibrium argument does not require that individual portfolio managers know the information content
of a trade - rather, they discover it collectively through the process of placing orders.

36
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40
Appendix A
Standard errors can underestimate the uncertainty in financial variables due to tail effects and temporal
structure such as bull markets or mean-reverting periods. In our analysis, we addressed the effect of
market drift by defining fair pricing in terms of beta-adjusted returns instead of absolute returns and
used bootstrapped standard errors to avoid assumptions on the shape of the underlying distribution. In
this section, we test the fair pricing condition further by splitting the data by random deciles, by quarter,
by volume and by trade size. The results show that we cannot reject breakeven in any of 10 bins in a
random partitioning of the data (Figure 9) or by quarter (Figure 10). Using quarterly bins reveals a
downward trend in both shortfalls and permanent impact tracking the decline in market volatility
following the US mortgage crisis.

Shortfall and Permanent Impact

Random bins, Excluding Cash Flows
60
50
40
30
20
10
0
0

Beta-Adjusted Shortfall

10

12

Beta-Adjusted Reversion Price

Figure 9: Shortfall and permanent impact for random deciles. We cannot reject breakeven in any of 10 bins in a
random partitioning of the data.

41

Shortfall and Permanent Impact by Date

Excluding Cash Trades
80
70
60
50
40
30
20
10
0
0

Beta-Adjusted Shortfall

10

Beta-Adjusted Reversion Price

Figure 10: Shortfall and permanent impact by quarter. We cannot reject breakeven in any quarter. The downward
slope of both shortfall and permanent impact reflect declining market volatility following the US 2008 mortgage
crisis.

In Figure 11a,b we consider shortfall and permanent impact by deciles of traded volume from start to
end of trade, normalized to a daily value by multiplying by

390
,where

t is the trade duration in minutes.

Figure 11a shows the results for small trades, comprising less than 5% of average daily volume in the
stock. Figure 11b shows the case of large trades. We cannot reject fair pricing in any of the 20 cases by
volume and trade size.

42

Shortfall and Permanent Impact by Volume

Small Trades Excluding Cash Flows
40
30
20
10
0
0

10

12

-10
Beta-Adjusted Shortfall

Beta-Adjusted Reversion Price

Shortfall and Permanent Impact by Volume

Large Trades Excluding Cash Flows
90
80
70
60
50
40
30
20
10
0
0

4
Beta-Adjusted Shortfall

10

12

Beta-Adjusted Reversion Price

Figure 11a, b: Shortfall and permanent impact by volume and trade size. We explore fair pricing in deciles of
contemporaneous trade volume normalized to a daily value by splitting the data into two sets by trade size. The
trades are classified as large or small according to whether the number of shares is greater or lesser than 5% of
the average daily volume in the stock.

43
Table 5 shows the average and standard deviation of the market makers P&L for each partition of the
data. Splitting the data by date produces the highest standard deviation (7.74), suggesting that
temporal coherence increases error bars on the unrealized P&L after reversion by roughly a factor of 2.
Deciles

Average P&L
(bps)

Standard Deviation
(bps)

Random

0.96

3.33

By quarter

1.64

7.74

Small trades by volume

1.47

4.50

Large trades by volume

0.78

7.63

Table 5: Error analysis on fair pricing evidence. The standard deviation on quarterly averages of the unrealized
P&L after reversion is approximately twice as large as for random deciles.

Appendix B
In fair pricing theory,

the shape of the impact function is determined by market participants'

expectations regarding the likelihood that a metaorder will continue or stop; because of this the tail
behavior of the size distribution determines the scaling exponent for impact as a function of trade
size. In this section we attempt to determine the distributions of trade durations and trade sizes. In
order to estimate the tail exponents accurately we removed the size>1% ADV filter. We find that trade
durations are consistent with a Pareto distribution with a tail exponent = 1.8 for durations of at least
one whole day (Figure 12). This is higher than the exponent 1.3 found by Vaglica et al. (2008) who
consider patches of directional trading by brokers on three stocks in Spain's BME and lower than the
exponent 3 predicted by Gabaix et al. (2006).

44

Figure 12: Distribution of trade durations. The probability density function of trade durations in minutes falls off
as a power law with exponent 2.8 (exponent 1.8 for the cumulative distribution). Spikes at multiples of 390
minutes reflects a preference by trading desks to start at the market open and end trades at the market close.

To analyze the distribution of trade size, we normalized traded quantity by the average daily volume
(ADV) to enable comparison across stocks with very different traded volumes. The average ADV is
defined as the 30-day trailing average of regular market hours volume. We find the size distribution is
consistent with a tail exponent = 1.5 (Figure13). In Figure 14 we show the distribution of trade sizes
for cash flows only. Cash flow trades are not well modeled by the Pareto distribution with exponent 1.5;
the distribution is consistent with a log-normal overall.

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Figure 13: Trade size distribution. The distribution of trade sizes normalized to Average Daily Volume (ADV) fits a
power-law decay with = 1.5, extending up to metaorders of 5-10 x daily volume.

Figure 14: Trade size distribution for cash flows. The size distribution of cash flow trades does not support the tail
exponent 1.5 found for metaorders overall; cash flows are well-modeled by a log-normal distribution over the
entire range of sizes in our sample.

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The distribution of trade sizes in shares is shown in Figure 15. The tail exponent is lower than that of
normalized trade sizes due to the larger number of stocks with a low ADV.

Figure 15: Trade size distribution in shares filled. The distribution of trade sizes in shares is distorted by the
sampling across stocks with very different daily volumes. Neither the log-normal or Pareto distribution provide a
good fit; we show a slope -2 (Cauchy distribution) for illustration purposes.

There are several prior results in the literature regarding the tail exponent of the order distribution. The
signs of order flow in equity markets have a long memory so that their auto-correlation function decays
slowly as where 0.5 (Lillo et al. 2005). As noted in Lillo et al., under a simple theory of
order splitting, the auto-correlation in order flow can be shown to follow from a fat-tailed metaorder
distribution with tail exponent = + 1. Gabaix et al. (2006) have a theoretical prediction of 3/2
consistent to our result. Vaglica et al. (2008) find an exponent 1.7 using brokerage data. They showed
that the size distribution of metaorders from a single source should be expected to be log-normal (once
sizes are normalized by daily volume to enable comparison across stocks) and that the fat-tailed size
distribution in brokerage data is an effect of the aggregation of data from many firms of different sizes.
The size of banks (Pushkin and Aref, 2004) and mutual funds (Gabaix et al., 2006) follow Zipf's law, i.e.
the cumulative probability that assets under management be greater than decays as 1/. Our data is
dominated by a few very large firms.

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Our sample of portfolio managers certainly does not represent an unbiased sampling of firm sizes. And
indeed, the data shown in Figure 15 is not sufficient to affirm that the distribution is better modeled by
a power-law tail than a log-normal. However, we find that the slope of the PDF distribution in logs does
appear to be approximately -2.5 for large trades. Bershova and Rakhlin (2013) also found that a lognormal size distribution improves on the Pareto distribution..