Research profile showing how past performance is a guide for future performance. Pensions could save by using best brokers.

1. Thaders, Brokers, Based on the research of Kumar
Venkataraman of Southern
and Money: Methodist University, Amber
Anand of Syracuse University, Paul
T/te Past is Your lrvine of the University of Georgia,
Present and and Andy Puckett of the University
of Missouri
Future
ith Wall Street bonuses under the spotlight, new The study reports that the quality of implementation is as important
evidence on the performance of Wall Street trad- as the investment idea itself. The research establishes the importance
ers offers more nuance. Trillions of dollars in stocks of trading costs for the performance of managed portfolios, mutual
are traded month after month in financial markets. funds and pension funds. lmportantly, it shows that performance
New research by Finance Professor Kumar Venkataraman of SMU rankings of institutional trading desks and brokers persist over time
Cox and co-authors shows that if pension plans and mutual funds pay and contributes to better understanding of the value addltion of ìarge
attention to the cost of implementing ¡nvestment ideas, they can save broker/dealers such as Goldman Sachs or JPMorgan, or niche play-
significant amounts of money for fund investors. ers, such as Freeman, Billìngs and Ramsey.
The choice of the trader who you select to execute the order The study examines a proprietary database of institutional investor
-
Author Venkataraman says, "Trader who are ranked high equity transactions provided by ANcerno, a consulting firm that moni-
- matters. executions perform well in the future. This is the clas- tors execution costs. The data contain approximately 35 million order
based on past
sic evidence for trading skill. This is particularly true for brokers. So tickets that are initiated by 664 institutional investors. These trades
broker selection should be based on past broker performance." were facllitated by 1,137 brokerage firms over a seven-year period
(1999-2005), representing $22.9 trillion in trading volume. The data-
lntermediaries Matter base is distinctive in that it contains a complete history of each order
Prior research has focused on the performance of money managers, ticket- each typically resulting in more than one execution, sent by
those at mutual funds, hedge funds and institutional plan sponsors. an institutional investor to a broker. The ANcerno database includes
However, there is little work examining the performance of trading pension plan sponsors such as CALPERS, the Commonwealth of Vir-
desks, who are responsible for trillions of dollars in executions each ginia, and the YMCA retirement fund, as welì as money managers
year. Recent work by other researchers says that manager sklll ac- such as MFS (Massachusetts Financial Services), Putman lnvest-
counts for less ihan half of a mutual fund outperformance (doing ments, Lazard Asset Management, and Fidelity.
better than benchmarks) and that fund characteristics are more im- Brokers ranked as best performers sustain their advantage over
portant. So, the authors ask: why would the fund be a source of rela- adjacent periods. The best brokers can execute trades with no ex-
tive performance? Can the trading desk be the explanation? Trading ecution costs. Similarly, the best (buy-side) institutional trading desks
costs have the ability to erode or eliminate the value added by money continue to outperform peers over adjacent periods. The best desks
managers. Porlfoìio managers rely on the buy-side trading desks to execute trades at negative trading costs, suggesting traders can cre-
implement their investment ideas. A trading desk can add value to ate positive portfolio alpha through their trading strategies. The au-
an ìnstitution's portfolio by supplying experlise in transaction cost thors find the results to be striking as the dataset contain difficult-to-
analysis. execute trades initiated by large investors.
56 marketsmedia magazine I july/august 2010

2. The combined effects of the institution and the broker are eco- ment trade management processes that assess the costs and quality
nomically large. For example, the tradrng cost difference between the of trades.
Iop 20"/" institutions trading through hop 20% brokers [top institution- From a regulatory perspective, the study should inform regulatory
broker pairJ and the bottom 20% institutions trading through bot- initiatives such as SEC Concept Re¡ease 57-12-03, which considers
Iom 2O% brokers [bottom institution-broker pairl is approximately 1 "whether mutual funds should be required to quantify and disclose to
percent. Thus trading costs significantly contribute to mutual fund investors the amouni of transactions costs they incu¡ include trans-
performance. The analysis indicates that almost half the difference action costs in their expense rat¡os and fee tables, or provide addition-
in the cost to execute a trade can be attributed to the trading desk,s al quantitative or narrative disclosure about their transact¡on costs.,,
choice of brokers, emphasizing the importance of broker selection. 'Best execution' has been the subject of recent regulatory attention
The study says that trading costs were not driven by the institu- under U.S. Regulation National Market System (Reg NMS) and Eu-
tion's investment style. ropean Union's Markets in Financial lnstruments Directive (MiFlD).
ln defining 'best execution,' regulators in the U.S. have emphasized
What the Best Do the fiduciary duty of brokers and fund managers to obtain the best
The study identifies a set of trading decisions that are associated w¡th value for the investment decision. Brokers provide a package of other
performance. related services to institutions such as prime brokerage services, lpO
o lnstitutions receiving poor executions specify low commission allocations, and research. There's no way of measuring these poten-
(or 'touch') execution venues, suggesting that they tend to focus on tially offsetting benefits. "ln reality,'best execution'is hard to mea-
explicit trading costs. However, this choice is sub-optimal and can sure, " states Venkataraman.
ultimately cost the institution. The savings in explicit commissions are
negated by higher trade execution costs. Trading Costs and Mutual Fund Rankings
.Simple strategies such as concentrat¡ng order flow with fewer Trading desks can contribute to positive outperformance for institu-
brokers help institutions receive better execution. tions. Venkataraman relays "Buy-side institut¡ons mutual funds,
. Brokers who specialize by sectors or industries, generally bou- -
pens¡on funds, and proprietary tradlng desks --{an save investors
tique brokerage firms rather than generalists, tend to provide better money by using the best ranked brokers. ln fact, they have a fiduciary
executions. duty to choose the best broker and our evidence indicates that they
o Higher explicit brokerage commissions are associated with better
are fa¡ling in their duty."
execution performance. This is contrary to research on mutual fund The cumulative impact of trading costs can dramatically affect the
where higher compensation to money managers (higher manage- returns to a ìong-term investor in a fund. According to the study,s
ment fees) is associated with lower fund performance. estimates, better trade execution processes alone can add an incre-
. Trading costs decline when the broker expends more effort in mental 62 basis points to a mutual fund's annual return (even more
working the order. for high turnover funds). Paying attention to trade execution can
. Well-capitalized brokers tend to provide significanily better ex- move the mutual fund several notches up the rankings tables and
ecution. Their capital, and the ability to provide a direct counterparty help maintain relative outperformance.
for difficult to execute trades, is a hard competitive advantage to rep- The cumulative dollar impact of trading desk decisions such as
licate. broker selection is large: an approx¡mate calculation suggests that
annual trading cost reductions could exceed $l billion if institutions
Disclosure to lnvestors and Regulation route their order flow to the best performing brokers instead of the
lnstitutional investors account for a large portion of stock ownership poorly performing ones.
and daily trading volume in financial markets. Understanding what "Performance of institutional trading desks: An analysis of persis-
drives institutional performance is of special interest to investors, tence in trading costs" by Kumar Venkataraman of SMU Cox School
money managers, and regulators. of Business, Amber Anand of Syracuse University, paul lrvine of Uni-
"Mutual funds should disclose trading costs along with the quar- versity of Georgia, and Andy Puckett of University of Missouri, is un-
terly performance," according to Venkataraman. Currenily, they only der review at a top tier finance journal.
report expense ratios. He observes. "Similar to expense ratros, imple-
mentation costs can impact fund performance and should be made Research summary written by SMU's Jennifer Warren.
transparent." lnvestment management firms are advised to ìmple-
marketsmedia magazine I july/august 2010 57