On November 8, 2018, John Wightkin, CFA, a senior trade consultant at TradeInformatics, spoke at the Vault Series of the CFA Society Chicago about how the process of examining trading costs can help preserve portfolio alpha.
According to John, “trading costs can represent close to half of active returns” and the process of analyzing and examining trading costs can help claw back those costs that preserve alpha. The dispersion of average trading costs can be between 3 and 48 basis points per the presentation. The process John outlined to combat these high costs has three basic steps:
- Alpha profiling, which is the analysis of the firm’s linkage and relationship between the portfolio manager, trader, broker and analyst. The “alpha profile” tries to identify the unique DNA of portfolio ideas and then link the process to return preservation and implementation.
- Return preservation, which means looking across different participation rates and liquidity buckets for opportunities which might not be apparent. The participation rate refers to identifying active vs passive relative to market flow and the liquidity buckets are determining what order size is relative to average daily volume.
- Implementation is the last step to be considered and ought to be low-cost and transparent. The client firm will learn how to take control of trade execution on a specific platform to prevent information leakage, but also use the platform as a way to receive information about market flow and trade reception.
A case study was provided where TradeInformatics examined a hedge fund with 30 traders but no central trading desk. When the trades were working in the desk’s favor, there was an average of 12 minutes between trades, but when trades were working against the desk, or positions were losing, the average time between trades lengthened to 40 minutes. The conclusion drawn was that actual returns were 5.9% lower than “expected return” based on the actual trading patterns.
Using a healthy lifestyle analogy, TradeInformatics concluded that to reduce trading costs, the trading desks should “lose weight and eat a balanced diet” which translates into slowing their trading down and doing it more consistently over both sides of the market, i.e. whether the trades are winning or losing.
Summary / conclusion: The takeaway from John Wightmkin’s slide presentation was to slow down and be more consistent with a firm’s trading practices. The time differential between winning and losing trades was antithetical to the traditional practice within investing of “cutting your losses and letting your winners run”. Trade Informatics often found that the opposite was the case.
Trade Informatics can provide more discipline around the trading / execution process, for which the goal is to ultimately lower trading costs and preserve portfolio alpha.