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DECEMBER 2OO4

COMMENTARY 82

MELTING ICEBERGS ln 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?'

We

identified three oossible sources of lornrer costs:

. . .

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

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The obvious question is: "what happened?" We identified three possible sources of lower costs: 1l changing market technology, 21 changing market structures, and 3l 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

and ZVUJ. \4/e recently sent al! clients a copr" of the Plexus-sponsored report by the

Tabb Grouo entitled "lnstitutional Equity Trading in America: A BuySide Perspective." (Available on Costs fell from a high of 122bp in 2000 down to 58 bp in

2003 (a 64 bp or 52o/o 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.

www.plexusgroup.com.) The report reviewed the changes occurring in technology and how those changes are impacting buyside traders. The key points: 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 - allowino traders to focus on the laroer

orders where they can add value.

advantage to the buyside from ECN's.

3. Aggregation across markets/ECN's has improved

However, the ECN numbers are understated. Many

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.

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 fellfrom -114bp to -59 bp. Direct ECN impact is muted, but ECN's continue to influence buyside behavior and force traditional brokers to keep costs competitive.

- disciplined tools - ensure that traders work orders in an efficient and relativelv

4. Algorithms

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

Commissions, surprisingly, are the one cost that has risen since 2000. This is a consequence of the shift

towards agency trading

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.

Gommissions Rise, Yet Erckerage Ccsts F:ll 50

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Changing Market Structure

2000

2001

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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

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The biggest change

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underlying equity prices (the average dropped from $43 in 2000 to $26 in 2003).

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i=+;ii But even as explicit commissions rose, increased agency

lower intraday volatility, with the caveat that costs would likely rebound once markets became more active. And

trading led to broker impact costs falling at an even faster

we were right - but for only a short period of time. lmmediately following 9111, and again during the lraq

commission) fell from 55 bp to 35

invasion, trading costs did rise, but they fell again in short order.

rate. On a combined basis, brokerage (impact

+

bp. For small caps, the drop was even greater (84 bp to 54 bp), but for MicroCaps (. $SOO MM), the drop is only from 77 bp to 68 bp. In these cases, penny commissions add up.

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.

Changing Buyside Behavior

smaller direct

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,

contribution to the drop in costs than we initially assumed. Their percentage of dollars traded grew from about 8% in. 2000 to 12o/o in 2003, lower than many would expect. Total trading costs for this class of brokers (including the delay cost of waiting foriseeking liquidity) fell from -52 bp to -48 bp. These numbers are slightly better than the overall average of -55 bp, but eliminating the commission

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

lronically, ECN's and ATS's had

a

advantage (2( vs 4-51) results in no additional cost

have again embraced the logic of diversification.

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

Changes in Desk Order Characteristics Avg. Shares

% Daily Vol

2 day l\/lomentum

2000

68,400

39o/o

2.O1o/o

2001

64,300

360/o

1.35o/o

2002

64,000

3OVo

1.12o/o

2003

60,400

31o/o

0.794/o

monitoring.

, : . What Abtaut Other Markets? t',," i,- ', ,, :'

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 1 8 percentage point reduction accounted for 47 of the 64 bp drop in toial 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.

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.

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Adve rse

2003

7o orders

31%

134/a

Cost

-261 bp

-234 bp

2003

2000

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2000

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55o/o

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-85 bp

2000

2003

Comm

Favorable

eutral

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2000

2000 2003 : lmpact

2000 2003 * Timing

Changes in Order Momentum

-48 bp

Costs dropped across the small cap spectrum, down 50% in both the Mid/Small cap range, and a 42o/o drop for Micro caps. Like the Large Caps, the MidCap ($1 - 108) cost droo reflects a combination of reduced momentum and improved relative liquidity.

2003 6%Y

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MicroCaps. And the MicroCap drop in momentum is smaller than the other cuts, consistent

with the smaller reduction

in

trading costs.

Equally impressive is the drop in the cost of Neutral orders. The next table provides some more perspective:

Changes in Small Cap Characteristics

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$1-108 Avg Mom.

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Avg.

% Dail;,

Vol.

Mom.

Vol.

Mom.

Vol.

2000

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109%

2.22

198o/o

2003

0.89

44o/o

1.38

1O5o/o

t.o/

217o/o

Ghanges in Neuiral Momentum Order Size & Costs +250K

< 50K

50 - 250K

2000

2003

% orders

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30

Cost

-168 bp

-/o

-84 bp

2000

2003

2000

2003

lo70

1A%

20o/o

zo-/o

-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 1.22oh) in the +250K set,.. by 610/o (to .66%) in the medium size and by 62% (to .25o/o) 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

% Daily

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 42o/o - reflecting the reality that these stocks continue to march to different drummers. 2003 European Equity Costs / Characteristics Size 2 day ($,000's) Mom.

o/o Daily Volume

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Total

EU

2.O4

62Yo

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1O9o/o

2.22

198o/o

460/o

US

0.89

44o/o

1.38

105%

1.67

217o/o

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The table below provides additional insights. When we comoare 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 or0ers. 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

orqers. Changes in European Characteristics Momentum

% Orders Cost

Order Size

Adverse

Neutral

Favorable

+250 K

11o/o

51Vo

5"/o

oc'/o

+67 bp

-57 bp

177 bp

50-250

< 50K

4Vo

20%

1

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hn

Focusing on Large orders, the first big difference is lower momentum for European orders (.9% vs. 1.3%). Butwe

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 Wiil the lcebergs Grow Again? Obviously, the last four years have deflated both market expectations and trading costs from the 3Q2000 oeak. 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 inflr-renee 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 offing. 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 Neurs

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Put this on your calendar! The Plexus Group 9th Client Conference is scheduled for September 18 - 20,2005 at fne Fairmont Turnberry /s/e Resorf & Club (http:/lwww.fairmont.com/turnberryisle/)

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11150 W. Olympic Blvd., #1000 Los Angeles, CA 90064

PH: 310.235.3700 FAX:

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Plexus Group rs a subsidrary of JPMorgan Chase, N.A. @

2005 Plexus Group, Inc.

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