With the 'unbundling' of research and increased transparency of execution costs, Per Lovén of Liquidnet Europe looks at the reform of the trading landscape.
Trade execution is emerging as an important part of the investment process as erosion of investor returns, coupled with global macroeconomic uncertainty, is changing the way in which asset managers look at the impact that execution costs have on performance.
The reform of the trading landscape started more than ten years ago with the idea of so-called ‘unbundling’ of research from execution, first put forward in a review of institutional investment commissioned by the UK Treasury and conducted by Paul Myners in 2001.
This was followed by the UK Financial Services Authority rules on the use of dealing commissions, which fell short of the Myners’s recommendations of total unbundling, but which nonetheless resulted in an increased transparency for asset managers by breaking down the cost of research and execution.
The old model, in which a broker supplied the asset manager with the research or idea for an investment decision and the asset manager paid a bundled commission which covered both execution and research, was being quietly reversed.
By the time best execution was introduced in the Markets in Financial Instruments Directive (Mifid) in 2007, the UK asset management community had begun to make progress towards unbundling the execution part of the trade from the research or investment advice given by their broker. For the first time, execution and research were priced separately, leading to a greater awareness and a more thoughtful approach towards execution.
Despite these efforts, more than a decade after the Myners Review, the picture that exists today is mixed and varies from one asset manager to another and from market to market. While the relative lack of progress towards unbundling reflects the difficulty that asset managers face in measuring the value of broker research, the cost of execution is more straightforward to understand.
The cost of execution
It has long been recognised that the larger portion of execution cost is not the commission that asset managers pay to the broker for executing an investment idea, but rather it is the implicit cost they suffer in terms of market impact once they execute their order in the marketplace.
To put this in numerical terms, the cost of slippage or market impact as a result of a large order placed can run up to hundreds of basis points. This, unsurprisingly, constitutes a larger portion of the costs and one that is likely to impact performance in the long run.
The importance placed on execution by Mifid was particularly timely, given the increased competition it introduced in the trading landscape and the emergence of new, light and dark trading venues. Trading desks within the asset management scene had to rapidly adapt from a world in which execution choice did not exist to an environment in which thoughtful execution could lead to improved performance.
Best execution as mandated by Mifid, however, has proved to be less effective than the policymakers originally aimed for. The policy document outlining a firm’s best execution policy does not always serve the interests of the end investor and seldom reflects the choice of execution venues post-Mifid.
The subjectivity of best execution policies aside, the picture is made more complex by the fact that the new type of trading venues are different in scope and motivation. Dark pools, for example, a label used to describe various types of non-displayed liquidity, are numerous but they do not all serve the same purpose and their performance varies greatly.
LiquidMetrix, an independent third party analytics company that compares different dark execution venues, found the average price improvement in April 2012 to be anything between four and 175 basis points. The opportunity cost of not executing on a venue is estimated to be, on average, higher than 1.5%. In a period of continuing low investment returns, such savings are increasingly relevant to asset managers looking for above-average investment returns.
Traditionally, execution has not captured the interest of individuals beyond the trading desks of asset management firms. This, however, is changing. Portfolio managers are begining to pay attention to the market impact their investment decisions have in a low liquidity environment, and dealing desks adopt more sophisticated ways to measure the impact of execution.
Execution impacts asset management performance in different ways. For example, asset managers that trade less liquid instruments such as emerging market funds or small mid-cap funds are likely to see more of a market impact. Therefore, execution will be a more important part of their investment decision.
While some European asset managers have made more progress than others in keeping pace with change that affects the performance of their portfolios, in the absence of a stringent best execution definition, and the lack of implementation of Mifid rules in some European markets, asset owners have a real opportunity to play a more active role in determining that the asset manager has an efficient dealing policy which maximises performance.
Asset managers that do not have an efficient execution policy are missing an opportunity to improve their performance. With returns way below historic highs, the case for change has never been stronger.
Per Lovén is head of Emea corporate strategy at Liquidnet Europe
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