Trading costs can be divided into explicit costs (e.g., commissions and fees) and implicit costs (e.g., market impact and execution risk). The Implementation Shortfall (IS) framework measures the total cost of trading, helping managers assess the efficiency of their execution strategies.
What is Implementation Shortfall (IS)?
- Definition:
IS is the difference between the hypothetical return of a paper portfolio (executed at the decision price) and the actual portfolio return, accounting for all costs.
- Expression:
IS is typically expressed in basis points (bps) relative to the total cost of the paper portfolio.
Key Components of IS
IS can be decomposed into four parts:
- Execution Cost:
- Delay Cost: Adverse price movement between order submission and execution in the market.
- Trading Cost: Adverse price movement due to the market impact of the trade.
- Opportunity Cost:
- Lost profit on the portion of the order not executed.
- Fixed Fees:
- Explicit costs such as commissions or other transaction fees.
Example: Implementation Shortfall Calculation
Scenario:
- A manager decides to buy 50,000 shares of Stock SJB at $20.00 (decision price).
- Limit Price: $20.50.
- Execution Details: 40,000 shares bought at an average price of $20.34.
- Commission: $0.02 per share.
- Closing Price: $20.55.
Step 1: Calculate Total IS
Step 2: Decomposing IS
Key Insights
- Execution Timing Matters:
Delays between decision and execution increase costs. - Market Impact:
Large orders or urgent trades often result in adverse price movements, raising trading costs. - Unexecuted Orders:
Leaving part of the order unfilled leads to lost profits, highlighting the importance of balancing urgency and cost efficiency. - Explicit Costs:
Though smaller in magnitude, fixed fees still contribute to overall costs and should be managed carefully.
Implementation Shortfall is a comprehensive metric that captures all trading costs, providing actionable insights to improve execution strategies. By decomposing IS into its components, portfolio managers can identify inefficiencies and refine their trading approach. 
