Efficient trade execution is crucial for portfolio managers aiming to maximise returns and minimise costs. Two significant implicit trading costs are delay costs and opportunity costs. Understanding and managing these costs can lead to better execution strategies and improved portfolio performance.
Delay Costs
Definition:
Delay costs arise from adverse price movements between the time a portfolio manager decides to trade and when the order is actually executed in the market. This delay can be due to time spent on internal processes, such as strategy formulation and decision-making.
Minimizing Delay Costs:
- Efficient Trading Practices: Streamlining pre-trade and post-trade analyses enables traders to make swift decisions on optimal trading strategies.
- Automation and Technology: Utilizing advanced trading platforms and algorithms can reduce execution times.
- Clear Communication: Ensuring timely and effective communication between portfolio managers and traders helps expedite the trading process.
Opportunity Costs
Definition:
Opportunity costs represent the potential gains lost when a portion of an order is not executed. Unfilled orders may result from market illiquidity or price movements away from the desired execution level.
Reducing Opportunity Costs:
- Alternative Investments: Allocating unexecuted funds to the next-best investment opportunities prevents cash drag.
- Realistic Expectations: Understanding market liquidity helps set achievable order sizes and limits.
- Flexible Strategies: Adjusting trading tactics based on market conditions can improve fill rates.
Analyzing Trading Costs
By examining trading costs, traders can:
- Establish Appropriate Benchmarks: Setting realistic price benchmarks based on market conditions.
- Determine Trade Urgency: Balancing the need for swift execution against potential market impact.
- Optimize Execution Methods: Choosing between high-touch and algorithmic trading approaches.
Example: Detailed Implementation Shortfall Analysis
Let’s delve into a practical example to illustrate how implementation shortfall (IS) can be calculated and decomposed into its components.
Scenario
- Order Details:
- Security: Future Recreation (FTRB)
- Order: Sell 100,000 shares
- Decision Time: 1:05 PM
- Decision Price: £2.56
- Trading Actions:
- Execution Method: High-touch agency broker with a limit price of £2.50
- Order Submission Time: 1:13 PM
- Market Price at Submission (Arrival Price): £2.59
- Executed Quantity: 70,000 shares
- Average Execution Price: £2.60
- Commission: £400
- Closing Price at End of Day: £2.54
1. Calculate the Total Implementation Shortfall (IS) in Basis Points
Step 1: Calculate Paper Portfolio Return
The paper portfolio assumes the entire order is executed immediately at the decision price without any costs.
Step 2: Calculate Actual Portfolio
Step 3: Calculate Implementation Shortfall
Step 4: Express IS in Basis Points
First, calculate the initial value of the paper portfolio:
Now, calculate IS in basis points:
Interpretation:
A negative IS indicates that the actual execution outperformed the paper portfolio. In this case, the trader added value by executing the sell order at higher prices than the decision price, resulting in greater realized gains.
2. Decompose IS into Delay, Trading, Opportunity, and Fixed-Fee Costs
a) Delay Cost
The delay cost measures the impact of price movements between the decision time and order submission.
Interpretation:
A negative delay cost indicates a favorable price movement for the seller during the delay, adding value to the trade.
b) Trading Cost
The trading cost reflects the difference between the execution price and the arrival price.
Interpretation:
A negative trading cost signifies that the trader executed the order at a better price than the arrival price, benefiting the portfolio.
c) Opportunity Cost
Opportunity cost accounts for the unexecuted portion of the order.
Interpretation:
A positive opportunity cost indicates a loss due to not executing the full order. The unexecuted shares could have been sold at higher prices, resulting in additional gains.
d) Fixed Fees
Fixed Fees (bps):
e) Total IS Breakdown
Summing up all components:
This matches the total IS calculated earlier, confirming the decomposition is accurate.
Key Takeaways
- Negative IS Indicates Value Added: In sell orders, executing at higher prices than the decision price benefits the portfolio. The trader’s actions resulted in a net gain compared to the paper portfolio.
- Delay and Trading Costs Can Be Negative: Favorable market movements during delays and effective execution strategies can turn these costs into benefits.
- Opportunity Cost Remains a Concern: Unexecuted shares represent lost potential gains, emphasizing the importance of realistic order sizes and effective execution methods.
- Fixed Fees Impact Total Costs: While smaller than other components, commissions and fees contribute to the overall IS and should be managed carefully.
Strategies to Improve Execution
- Monitor Market Conditions: Stay informed about price movements to time order submissions effectively.
- Optimize Order Sizes: Balance the desire for full execution with market liquidity to minimize opportunity costs.
- Choose Appropriate Execution Methods: High-touch approaches can add value in certain market conditions, as seen in the example.
- Continual Analysis: Regularly decompose IS to identify areas for improvement in trading strategies.
By understanding and managing the components of implementation shortfall, portfolio managers and traders can enhance execution performance, reduce costs, and ultimately achieve better investment outcomes.
