Global Head of Equity and Currency Trading Barclays Global Investors San Franciscoost people say they know best execution when they see it, but my goal is to get people to focus on what can be done before the trade so that best execution can be known before it is seen. In this presentation, I will describe a process for quantifying trading performance that can be integrated into the investment decision.One way to envision transaction cost management is as an equilateral triangle. The first side of the triangle is the measurement of post-trade performance. The second side of the triangle is forecasting, where estimates of the costs to trade are calculated. The reason to have forecasts is to incorporate the expected trading costs into the portfolio optimization process so that the costs can be managed (the third side). When the trade arrives at the trading desk, the trader's job is to manage the gap between the portfolio manager's or model's expectations of trading costs and the reality of the market in which the trader operates. The ultimate goal is to have the performance of the trading function match or beat the expectations under the model. These three sides of the triangle-measurement, forecasting, and management-form the framework of my discussion. MeasurementAn optimal trading strategy begins with the accurate measurement of trading costs and the implementation shortfall. The concept of implementation shortfall is not new. It was first raised by André Perold back in the late 1980s. 1 Over time, it has been revised, and now every investment management shop seems to have its own version. Components of Trading Costs. Following are the quantitative components of trading costs.■ Commissions, fees, and taxes. These costs are self-explanatory and unavoidable.■ Bid-ask spread. If the order is small, the spread may be the only additional cost.■ Market trend. When a trader is executing an order, the market may be trending in favor of or against the order. That effect needs to be factored into the trading costs, even though it is beyond the trader's and the portfolio manager's control.■ Liquidity impact. Liquidity impact arises when an order is larger than the inside market or requires more immediate liquidity than liquidity providers can provide. At this point, the trade becomes visible to the rest of the market because of its size. Because of the immediate demand on liquidity, trading costs will be higher.■ Opportunity costs. Opportunity costs arise when an order is not filled the same day that it hits the trading desk. Sometimes, orders take a few days to fill. Consequently, the portfolio manager is missing out on any intraday or day-by-day returns until the order is filled.Measuring trading costs entails looking at six components: commission, bid-ask spread, market trend, liquidity impact, opportunity costs, and slippage. These components combine to determine the implementation shortfall. But trade cost management requires more than just measuring completed trading costs; it requires forecasting the costs of futur...
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