Melting Icebergs

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®

B u i l d i n g

B e t t e r

P e r f o r m a n c e

DECEMBER 2004

C O M M E N TA RY 8 2

MELTING ICEBERGS In Commentary 68 of October 2001, we noted that transaction cost icebergs were drifting, but the advent of decimalization and a changing market environment made the direction a tough call. Early indications were towards lower costs, but we feared higher costs. We were wrong! The obvious question is ‘what happened?’ identified three possible sources of lower costs:

We

• changing market technology – making buyside desks more efficient and reducing brokerage costs, • changing market structures – decimalization has reduced impact without increasing liquidity search costs, and • changing buyside behavior and composition – orders have much less momentum and are more liquid, and despite the rise in hedge funds, volatility is at an 8 year low. All three have contributed to lower costs and, consequently, to lower PAEG/L’s®. But we see signs that costs are flattening. As money flows back into equities and starts moving from sector to sector the trend may change once again. Stay tuned. The chart below shows the dollar weighted trading costs for US Large Cap trading between 2000 and 2003.

150

Shrinking Large Cap Trading Costs

120 90 60 30 0 2000 Timing

2001

2002 Impact

2003 Comm

The obvious question is: “what happened?” We identified three possible sources of lower costs: 1] changing market technology, 2] changing market structures, and 3] changing buyside behavior (and composition). We will discuss each of these along with their possible contribution to the overall cost drop. We will then discuss what we are currently seeing – and try to provide some ‘auguring’ into what costs are likely to do in the near future.

Changing Technology We recently sent all clients a copy of the Plexus-sponsored report by the Tabb Group entitled “Institutional Equity Trading in America: A BuySide Perspective.” (Available on www.plexusgroup.com.) The report reviewed the changes occurring in technology and how those changes are impacting buyside traders. The key points:

Traded returns net of costs rose nearly +50 bp, showing that reducing costs had a positive impact on returns. Costs fell from a high of 122 bp in 2000 down to 58 bp in 2003 (a 64 bp or 52% drop). More importantly, traded returns net of costs rose nearly +50 bp, showing that reducing costs had a positive impact on returns. The cost drops were similar in percentage terms for all Market Caps, across Large and Small desks, and across other Regions.

1. OMS systems have reduced the delay between the time that orders hit the desk and the time that traders can actually start to trade. 2. FIX and OMS connectivity has improved routing of smaller or very liquid orders for automated execution – allowing traders to focus on the larger

orders where they can add value. 3. Aggregation across markets/ECN’s has improved access to liquidity – and more than offset the reduction in dealer liquidity due to decimalization. Further, capturing a montage on markets may actually improve information that was lost when markets became fragmented. 4. Algorithms – disciplined tools – ensure that traders work orders in an efficient and relatively inexpensive manner. Algorithmic trading holds great promise, but appears to be used primarily by hedge funds, brokers, and a small handful of traditional buyside firms. Most buy-side firms continue to use MOC, MOO, or VWAP strategies; with the primary emphasis on accessing liquidity rather than cost minimization. Surprisingly, we don’t see cost differences yet between clients using sophisticated algorithms and those who trade more naively. Small desks routing orders to brokers had just as great a cost drop as those with sophisticated strategies. While this may change over time, the biggest advantage of technology appears to be making buy-side traders and brokers more efficient.

Changing Market Structure The biggest change is decimalization. We looked at the early impact in 2001, and found that despite fears to the contrary, trading costs were already coming down. We attributed the drop to much lower intraday volatility, with the caveat that costs would likely rebound once markets became more active. And we were right – but for only a short period of time. Immediately following 9/11, and again during the Iraq invasion, trading costs did rise, but they fell again in short order.

advantage to the buyside from ECN’s. However, the ECN numbers are understated. Many traditional brokers either have their own ECN or use other ECN routers. Full service brokers have been the early adapters of ECN routers, and their use between 2000 and 2003 grew from 50% to 59% while their costs fell from –114 bp to –59 bp. Direct ECN impact is muted, but ECN’s continue to influence buyside behavior and force traditional brokers to keep costs competitive. Commissions, surprisingly, are the one cost that has risen since 2000. This is a consequence of the shift towards agency trading in NASDAQ plus lower underlying equity prices (the average dropped from $43 in 2000 to $26 in 2003).

70 60 50 40 30 20 10 0

Commissions Rise, Yet Brokerage Costs Fall 8 10 15 15

47

2000

37

2001 Impact

29

20

2002

2003 Comm

. . . changes in market structures and trading skills/tools will have a lasting influence, but . . .

The second significant change was the 1997 Order Handling Rule and the ATS Act. This opened up the NASDAQ to both ECN’s and to Alternative Trading Systems (ATS’s). The result was an agency alternative for the retail investor, which in turn attracted greater flow from the institutions. Ironically, ECN’s and ATS’s had a smaller direct contribution to the drop in costs than we initially assumed. Their percentage of dollars traded grew from about 8% in 2000 to 12% in 2003, lower than many would expect. Total trading costs for this class of brokers (including the delay cost of waiting for/seeking liquidity) fell from –52 bp to –48 bp. These numbers are slightly better than the overall average of –55 bp, but eliminating the commission advantage (2¢ vs 4-5¢) results in no additional cost

But even as explicit commissions rose, increased agency trading led to broker impact costs falling at an even faster rate. On a combined basis, brokerage (impact + commission) fell from 55 bp to 35 bp. For small caps, the drop was even greater (84 bp to 54 bp), but for MicroCaps (< $500 MM), the drop is only from 77 bp to 68 bp. In these cases, penny commissions add up.

Changing Buyside Behavior Perhaps the biggest contributor to lower costs is the change in buyside behavior. One of the most striking is the reduction in manager and analyst expectations. As a result, we see less chasing of new market favorites and, more importantly, less panicked flight due to bad earnings. In addition, the influence of retail day traders has been greatly reduced. While Hedge funds, the new wave of investors, have become a significant market participant, their quant orientation has not led to increased volatility (volatility is at an 8 year low). Managers have also pared back illiquid holdings, and have again embraced the logic of diversification.

Changes in Desk Order Characteristics Avg. Shares

% Daily Vol.

2 day Momentum

2000

68,400

39%

2.01%

2001

64,300

36%

1.35%

2002

64,000

30%

1.12%

2003

60,400

31%

0.79%

While reducing the liquidity demands is helpful, the biggest change and contributor to lower costs appears to be the drop in momentum. As the table below reveals, the percentage of momentum outliers fell dramatically since 2000 (Adverse Momentum fell to 8.8% of 1Q04 orders). While there has been little change in the cost of Adverse momentum orders, the 18 percentage point reduction accounted for 47 of the 64 bp drop in total costs since 2000. On the flip side, the buy-side also gave up some of the captured gains for favorable orders, but the effect was minimal.

also bottomed in 3Q03, but have remained stable, but with a greater divergence of individual client results. The momentum/size/cost relationship will bear continued monitoring.

What About Other Markets? Most of the discussion above has focused on US large cap stocks. However, we saw similar cost and characteristic trends in Europe and in smaller cap stocks. The first set of charts looks at US small caps. Small Cap Costs Have also Dropped

300 250 200

$.5-1 B

$<.5 B

$1-10 B

150 100 50 0 2000

Changes in Order Momentum Adverse

Neutral

2003

2000

Timing

2003

2000

Impact

2003

Comm

Favorable

2000

2003

2000

2003

2000

2003

% orders

31%

13%

55%

81%

14%

6%

Cost

-261 bp

-234 bp

-85 bp

-48 bp

+35 bp

+4 bp

Costs dropped across the small cap spectrum, down 50% in both the Mid/Small cap range, and a 42% drop for Micro caps. Like the Large Caps, the MidCap ($1 – 10B) cost drop reflects a combination of reduced momentum and improved relative liquidity. But only lower momentum helped the Small and MicroCaps. And the MicroCap drop in momentum is smaller than the other cuts, consistent with the smaller reduction in trading costs.

. . . markets have a knack for repeating mistakes, and a move towards less disciplined, more costly stock selection is inevitable. Equally impressive is the drop in the cost of Neutral orders. The next table provides some more perspective:

Changes in Small Cap Characteristics $1 - 10 B

50 - 250K

< 50K

2000

2003

2000

2003

2000

2003

% orders

64%

56%

16%

18%

20%

26%

Cost

-168 bp

-84 bp

-93 bp

-50 bp

-49 bp

-29 bp

Two changes stand out; a higher percentage of small orders and lower costs across all sizes. We don’t have momentum distributions for each size cut, but the average momentum fell 55% (to 1.22%) in the +250K set, by 61% (to .66%) in the medium size and by 62% (to .25%) in the small trades. These numbers go a long way towards explaining the cost drops. We found that the percentage of large orders bottomed in 2Q03 and have risen each quarter since. Overall costs

< .5 B

% Daily Vol.

Avg. Mom.

% Daily Vol.

Avg. Mom.

% Daily Vol.

2000

2.04

62%

2.39

109%

2.22

198%

2003

0.89

44%

1.38

105%

1.67

217%

Changes in Neutral Momentum Order Size & Costs +250K

$.5 - 1 B

Avg. Mom.

The net conclusion is that Mid and Small Caps have benefited as much as Large Caps in both the changing marketplace, technology, and manager behavior. But the MicroCap response has been more muted – although costs are down 42% – reflecting the reality that these stocks continue to march to different drummers. 2003 European Equity Costs / Characteristics Size 2 day ($,000’s) Mom.

% Daily Volume

Timing

Impact

Comm

Total

EU

2.04

62%

2.39

109%

2.22

198%

46%

US

0.89

44%

1.38

105%

1.67

217%

31

The table below provides additional insights. When we compare the 2003 European measures in the table to US large caps, we find: • Consistent percentages of momentum outliers. • Europe also has a higher percentage of very large orders. • European costs are lower in each momentum category, but only in the largest order category. This is a consistent pattern. • The difference in large Order costs is all broker impact – 7 bp for European stocks vs. 27 bp for large US orders. Changes in European Characteristics Momentum Adverse

Neutral

Order Size

Favorable

+250 K

50-250

< 50K

% Orders

11%

51%

5%

65%

14%

20%

Cost

-177 bp

-37 bp

+67 bp

-57 bp

-50 bp

-33 bp

Focusing on Large orders, the first big difference is lower momentum for European orders (.9% vs. 1.3%). But we suspect that the real difference is the combination of a smaller stock universe for large orders, less underlying momentum, and greater emphasis on Full Service brokers. Reducing broker’s risk allows for better bids/offers for sizable trades – and leads to lower overall costs.

More Global Warming? Or Will the Icebergs Grow Again? Obviously, the last four years have deflated both market expectations and trading costs from the 3Q2000 peak, but is 2003 a cost bottom? The real question remains: what do we see as the future trend in costs? 1Q04 Large Cap and European costs were slightly lower than the 2003 average, but US Small Cap costs started to rise in 4Q03. The confluence of change in the exchange structure, trader skills and tools, and investor behavior has resulted in radically different markets in a short period of time. As the investment environment evolves, changes in market structures and trading skills/tools will have a lasting influence. But we are not as certain about behavior; market participants have a knack for repeating mistakes, and a move towards less disciplined stock selection at some point is guaranteed. We guessed once that higher costs were in the off i n g . This time, with costs at a much lower level, we make the same (albeit safer) call. But we doubt that trading costs will approach the 2000 level any time soon.

Plexus News Put this on your calendar! The Plexus Group 9th Client Conference is scheduled for September 18 - 20, 2005 at the Fairmont Turnberry Isle Resort & Club (http://www.fairmont.com/turnberryisle/)

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