Capturing the

Research Advantage
Inforrnation reduces uncertainty, but good exeottion is essential to investrnent success.

Mark Edrvards and-Wayne H. Wagner

Berween the idea

A -,.1 ,L-
rr.v --^l;-,
r!|lsL'
rulu

Berween the monon

And the act
Falls the Shadow
T.S. Elioc, "The Hollow Men"
-
*adages
eter Bernstein [1997] cites rwo to
captLrre the major lessons of capital market
theory: "Nothing ventured, nothing gained,"
and "Don't put ali your eggs in one basket."
The market rewards risk-cakers for invesung in uncer-
tain sicuations, and diversificasion spreads the risk to
avoid disasters.
What is the risk that Bernscein refers to? Capital
market marhemaricians equate risk with statistical vari-
abiliry. At best, this is an after-che-fact solurion to a
betbre-the-fact problem. Robert Arnott [199a] by
conuast adopts a more psychological vielv: "Il isn't risk
if rt isn't unconfortable." Uncertainry about future out-
comes creates discomfort, and dealing with dtscomfort
and r.mpertect information is the essence of rcdvc
invesrment managemenc. If the market conlLrms a deci-
IvIARK EDWARDS rs drrector o[ sion, uncertai.nry is reduced. The decisions are then
the Plexus Group in Los Angeles timely but potenrially expensive to impl.emenr.
- -
(cA e0064).
IMPACT OF COMIVIISSION
WAYNE H. WAGNER is chair- REDUCTION ON RISK
mrn of the Plexus Group rn Los
Angeles. Exhibits 1 and 2 summarize a srudy of potenrirl

CAPTUR]NG THI, RESEARCH,\DVAN'f AGE SPRING I999

1 8
EXHIBIT 1 effective stock selecrion.
COSTLESS RETIIRNS FROM The first impulse of concerned managers is to
SECTIzuTY SELECTION identiflz excessive execution costs as the source of per-
Round-Trip
formance leakage. Sponsors and regulators have 3umped
Buys Seils I Hrrlrc
-
\Fll(l on this bandwagon, pressing managers, brokers, and
exchanges to lower commissions and intraday impact.
6-Wk. Decisron Retum ln response, desks have mrnrmrzed these direct costs to
Absolute +5.47% -2.21% +3.20% where they now account for only 20% of the total
- Decision Retum
6-Wk. shorrfall. Yet che performance gap persists.
Market-Adjusted. +3.28% 4J2% +3J6%
-
*Market-adjusted
return subcracts the market movement over the TFIE "ICEBERG'' CFIARACTERISTIC OF
srx weela post-decision. TOTAL TRANSACTION COSTS

The visible and hidden costs of trading resemble

EXHIBIT 2 an iceberg. Ac the "tip of che iceberg" iie commissions
COSTS TO CAPTIJRE RESEARCH ADVANTAGE
the smallest component. In order of increasing
-obscuriry
but no iess punishing lie rntraday bro-
Round-Trip - interday tinring delays, - and opporturury
Buys Sel]s (Buys - Sell$ ker impact,
'We represent this' idea in
costs due to missed trades.
Total Execution Cost -2.44% -4.74% -3.28% Exhibit 3.
Absoiute Return Exhibit 4 decomposes the total shortfall (the ice-
Net of Costs +2.97% -2.95% -0.08% berg) for this study. The first column of numbers shows
Market-Adjusred Return
Net of Costs +0.84% 4.86% experienced costs for the traded/untraded shares.
-0.01%
Multiplying the raw numbers times the completion rate
gives the weighted contribution to total cost.
and actual rerurns over a six-week period. Six weeks is When traders and managers recoil from deci-
suficient to measure the short-term value of a firmt sions due to high commission and impact costs, cap-
decisions while accuraceJy assessing implementation tured returns drop as a direct result. In fact, the costs
cost (see Wagner and Edwards [1998]). In this study we have not been avoided, buc merely slufted to the more
measure decision value and costs from desired date of insidious cost categories of delay and opporrunity (the
-W'e
decision through the subsequent trades. then com- shaded components in Exhibit 5).
pare end-of-period price ro the price at the time of Commissions account for only 5% and broker
decision and to the actuai trade price, revealing both impact only 14% of cotal implementation costs.
potentiaL and captured return. Togerher, delay and opporrurury costs accounc for more
Exhibit 1 shows the potential buy and sell
returns (excluding any trading costs) for over forry
investrnent manager clients for the second and third EXHIBIT 3
quarters of 1997 . Exhibit 2 shows the captured rerurns IMPLEMENTATION COST "ICEBERG"
for the same buys and sells, comparing decision price to
net trade price. it shows that the cost of getting ideas
into portfolios offsets the research advantage. 'We see
chis pectern repeetedly each quercer.
These runaway execunon cos$ were largely
ignored until the 1990s. All the star appeal in active
management concerns stock selection (picllng win-
ners) and not green eyeshade cost accountrng. Yet, with
index funds grabbing a24o/o market share of 1997 pen-
sion equiry assets, managers are becoming aware that
efici.ent cost control is as importrnt co net rerurn as

SPR]NC I999 fHEJOURNAL OF PORTFOLTO M NACEMENT 19

EXT{IBIT 4
ACTUAI INTPLEMENTATION COSTS
Cost x Completion Rate = Net Cost

Execurion Cosu Commission -R- hn

'r -R" hn
"r
Broker Impact -?-l hn 94%

Postponement Costs Timing Delay -l

t1 hn
-106 bp
Opportuniry -383 bp 6%

Tocal Implementation Cost -160 bp

than 80% of the shortfall. These costs are not due to
trading badly; they are dLre to not trdding when it would
be advantageous but more cosdy to do so.
- -
The raw opporturury cost is the forgone return
for the unexecuted shares. The missed rrades would
have returned 383 bp over six weeks had they been
traded at the decision prices, whjle the shares acrually
traded returned only 147 bp. Emphasizing low-cost
brokerage worsens performance lvhen "safe" low-cost
decisions are emphasized, while more expensive but
more valuable decisions are deferred or abandoned.
Expanding on Berruteint first saying, tailing co
"venture" cheam the porrfolio of gains, but aiso adds
hidden costs, thus hurting performance in wvo ways.
THE PERSISTENCE OF PRICE MOVEMENT
This brings us to Bernstein's second concept:
diversification. Managers make many investment deci-
si.ons,yet neither manager nor trader knows a priori
lvhich ideas are winners, even thoLlgh the overall selec-
cion process demonsrrabiy adds value. Trading only
when the market provides low-cost execucions leads to
adverse selection: an executed ser oftrades chat lags the
returns of the desired trades. To wrn the active man-
agement game, then, the trader's 6rst goal nust be to
place all the manager's bets to trade all the orders.
'W'hile -
decisions add value on auerdge, not every
decision will be a winner. According to our date, only
55% of decisioru add vah-re. Professional money man-
agers put great falth in their research processes, yet reaP
benefit only when che overall market comes to agree-
menc with rheir logic.
To overconre the ftustration of markets thai are
"out of sync," managers may implement positive price
feedback timrng strategi.es to emphasize those stock picks
for which the market is concurring. Traders, in con-
East, are drawn to cheap liquidiry which leads to pur-
suit of negariue pricefeedback sitr-rations. This places man-
agers and traders ac cross-purposes.
The result is that many of the
manager's best
decisions either become underweighted or are never
executed. Meanwhile the weakesr ideas whi.ch are
the easiest to trade
-
end up firlly executed, thereby
-
dominating returns and leading to underperformance.
PRICE PERSISTENCE

EXHIBIT 5 We show that rimely manager decisions embody

RELATIONSHIP AMONG
sufficient pri.ce persistence over a slx-week lvindow to
IMPLEMENTATION COST COMPONENTS
validate a posirive feedback approach. Then rve shorv
that market confirmacion srgnals can be used to help
manager and crader identify l,vhich decisrons to
emphasize or co avoid. Finally, rve sho.,v that traders all
too often fail to use chis confirming intbrmation,
focusing instead on di.scovering cheap liquidiry and
reducing trading costs. The result is an operational
drrg on Perforrnence'
posidve feedback sraregies rely on price persis-

c^pTuzuNc TllE R-ESEARCH .\DVANTAGT SPRING 1999

2 0
tence. Although we cannot argue in favor of technical
models for stock-picking, we find that rinring overlays
add value to fundamental stock selection. 'While large
trades impact stock pricing for a short period,
inevitably prices reflect the composite of ail investors'
judgments. Thus persistence reflects the flow of infor-
mation as i.nvestors seek a valuation consensus.
Over time, fundamentals have to win. But in the
slx-week horizon used to analyze executions, trends
dominate. Exhibit 6 summarizes a more detailed srudy
of the same 1997 data.* We group trades according to
strong, neutral, and weak price momenrum categories
based on rwo-day price returns prior to decision. Buys
rising or sells falling more than 4o/o ere iabeled strong,
while buys falii.ng or sells rising more than 4Yo are
labeled weak. We then calculate market-adjusted thirry-
day returns for each momentum group.
The numbers in the firsr coiumn in Exhibir 6
show refurns and the percent of observarions &om the
total set, based on these inirial momentum groupings.
The strongest orders result in the best eventual returns,
while the weakest orders continue to lag.
Next, we subdivide each momentum group
based on price changes for the rwo days Jollowing the
initial order. Buys into srrengrh rhat conrinued to rise ar
Ieast 2Yo and sells inco weakness rhat dropped atleast2Yo
are viewed zs confrmed. Reversions of greater than 2o/o
are flagged ts reuersals. Al1 orher orders (che majoriry of
the observations) are labeled as flat. We rhen calculare
thrrry-day marker-adjusted rerurns on each subgroup.
Managers Seek Positive Feedback
This study shows that the best performance,
exclusive of inr.plementation cost, comes 6-om selecdng
stocks for which the market currently appreciates the
news. The odds of selecting winners increase when the
favorable tend is confirmed in the wvo days following
EXHIBIT 6
THIRTY-DAY RETIIRNS FOR LARGE.CAP BUYS
30-Day Market-Adjusted Return (% obsewati.ons)
Srrhcenrrent
Inidal N{omentum Retum (% obs.) Confirmed
Buying rnro Srrength e.6% (7%) 17.1%
Neutral Momentum 2.1.% (8670) ss%
DUylng lnto Weakness -8.0% (7%) -rs.8%
SPRING 1999
the trade. Conversely, falling stocks rhat conrinue ro fall
show the weakest returns; these are the losing bets. (But
they will be cheap ro rrade.)
As a practical rool, market confirmacion can
point managers and traders in the direction of the best
deci.sions. Indeed, we find that momentum and growth
managers often use market confirmation to add to
existing orders. Thus, the trade desk plays a critical
feedback roie in helping rhe managers decide which
orders to pursue aggressively.
The interesting parrs of Exhibit 6 are on rhe
exlremes: the relative handful of trades that show
strong or weak price signals. Managers wili want to
pursue stocks showing price strength and deemphasize
stocks with weak prices. As we will show, rrading
problems arise in deairng wirh these extremes, noc in
dealing with the bulk of the orders rhat show less
volatile price movement.
'W'hy
do these trends persisr? Managers often say
that good news begets more good news. 'We believe a
rnore likely explanation is rhat trading inrerest begets
more trading interest. This is not an argurnent for
momencum management. Rather, it is an encourage-
ment for better manager-trader coordination. Tiaders
can provide addicional information thar helps steer man-
agers away from the least successfi:l stock selecrions.
Traders Seek Negative Price Feedback
How do rising buys and falling sells afi-ect the
trading process? The evidence shows a conflict of inter-
est. Whiie manasers are oriented toward ma.xim:zing
returns, trading displays higher sensitiviry ro cosrs.
Where managers seek positire price feedback, rrading dis-
plays a negatiue priceJeedback parrern.
Exhibit 7 shows the development of rerurns as
large institutionai orders are worked for several days.
The bars represent raw returns (rhe difference berween
Price Tr'end Condicion 2 Davs After Order
Flat Revened
(37%) 5.6% (41%) 4.s% (22%)
(15%) 2.7% (67%) -3.3% (17%)
(31%) -4.8% (47%) -3.8% (22%)
THEJOURNA]- OF PORIFOL/O MANAGEMENT 21
EX}IIBIT 7
DAY-TO-DAY TRADING
EMPHASIZES CHEAP STOCKS
150
17q
100
^
8ru
icu
;25
-o
tr10t5
f! Tmded Retum I Unerecuted Share Retum
- promises the most valuable decisiors. Unfortunately,
the price when the desk recerved rhe order and the
closing price) for borh rraded shares (wtr-ice) and as-yec
unexectrted shares (black) as days move from the release
dace (0) to fifteen days posr-decision. The modesr rrad-
eri return implies rhat rhe bulk of trading acriviry occurs
in response to neutral or weak price movement, lvhile
the much stronger tmexenfted share returns reflect reluc-
tance to trade if the pocenrial cost is high.
This pactern is represenrative of most desks:
Orders with strong price moves are often deferred in
hopes of price reversion, .,vhile rhe flat (cheap) trades
are quickly execnred.
Exhibir I shows rhe impact of rhis behavior on
costs. As rhe stronger residual shares are execured, che
mareinal cost per sh:ire (black) more rhan quintupJ.es.
Irorucally, these trades appear cheap in terms of inrra-
day market impacr by the dme they are execured, buic
performance has been eroded by the hidden delay cosrs.
A mrnager lve knolv once described his trader as
someone who was "congerutally unable to step up."
This telling statement sholvs horv dift-erenrly rnanagers
and traders perceive risk. To a manager, rhe risk in a
stock is the possibiliry of nor achieving expecred price
growth based on fundamenrai research. The trade desk,
holvever, gauges risk reladve to recent tradino r:rnqec
a much shorter horizon. -
When i.nformarion flow is low, prj.ces often move
r,vithin a narrolv band, and lead to lorv-cosr trading
opportunities. Danger arises when prices move oucside
normal ranges. When rrend takes over, trading needs to
% freded becorne more aggressive. The crader lvho delays com-
rraders' all-coo-human terrdencies are abetted by spon-
sor pressure to dance to the cos[-minimization cune.
IMPACT OF MANAGEMENT STYLE
ON TRA.DING COSTS
Exhibic 9 shorvs that grorvth managers issue
many more strength-oriented orders than value man-
agers, 16% versus I0% for lrrge-cap and 23% versr.rs
1.4Yo for small-cap. Nore that value management often
doesn't mean contrary even value managers fte-
-
quently seek price confirmarion.
Value traders often believe they have much high-
er percentages oFweak orders, justifiTing a tendency to
trade with minimal impact. Exhibir 9 relis a diff'erenr
story for weakness-oriented orders. Value managers
issue only a siighciy higher proporrion of conrrrry
orders than gror,vth managers, 8% versus 7% for large-
cap mxnagers and 10% each for small-cap managers.
Both groups are equally rempred ro rake advantage of
price breaks co iruciace accion.

EX}IIBIT 8
GROWING INCREMENTAI COSTS
EX}IIBIT 9
INCREASE TOTAI COSTS \VHAT PERCENT OF ORDERS
REFLECT MONIENTUI{?

SCVaI

i SCGro

LCVaI

LCGro

Erdo.dcd Itudrcq
-rlrdd
?, CAPTURINC TH€ RISEARCH ADV,\NTAGE
SPRING 1999
 Fxhibir 10 compares the trading and opporruni-
ry costs for growth and value managers under condi-
tions of buying strength (left columns) or buying weak-
ness (right coiumns).
'We see that growth
funds rrade strong orders
aggressively, resulting in large impact but more modest
trmrng cost. Value funds should show high timing and
opportuniry coscs offset by minimal impact.
Both growth and value desks show high costs in
strength situarions, in contrast co much smaller trading
gains in weak situations. Gains for borh sets are less than
half the size of the costs at the other end of the spec-
trum, again suggesring that traders of all stripes are
drawn to rapid trading when Lrquidiry is cheap.
Th c,rmmo',ry. the data ShOw that manager deCi-
sions add value- However, much and frequently all
of the decision value is iost due- to lack of coordina-
-tion befween trader and manager. Our study shows chat
price trends persist, and traders r,vho routinely shy away
from high cost while seizing cheap liquidiry work
counterproducrively to their managers. Irt been said
many times before: The trend is your friend.
CAPTIIRING THE RESEARCH ADVANTAGE
Actiue investment management just that: acliue- is
/y seeking and securing superior stocks, end actively
removing from the porrfolio stocks wirh no particular
appeal at current prices. Thus, buy and sell decisions are
the drivers of active rerurn. Exhibit 2 shows that active
decisions add value, but not enough to overcome the
cost drag. Capturing the potential shown in Exhibit 1
is the challenge of active management.
Implementation coscs nr-ake sense only when
weighed against the benefir of enhanced performance.
Active managers balance the expected value of invest-
EXHIBIT 10
GRO.WTH AND VALI-TE COST SOURCES
a 1oo
;30 slrcng ode6 FIq
' Weak Otde6
g.* -
j -zoo
re J
@
Grgwth Vdw Growth
ITiming tr lmpact lopportuniq
SPRINC 1999
ment ideas against 1) the uncercainry rhat the informa-
tion is correct, and 2) the cosr of executing che trade.
Managers, we observe, are very good at the first skill.
Coming to terms with cost is the craders' chal.ienge.
The cradert Job is to capture rhe value of rhe
investment idea at minimal cost, balancing three addr-
trve cost sources: 1) comm,rssion and price rmpact on
crade compledons, 2) timing efrects generated from
delayed trading, and 3) opporturury cosrs from aban-
doned trades. Traders are good at conrrolling visible
costs, but excellence in the other rwo requires good
communication with the manasers.
INCORPORATING TR,q,DING INF ORMATION
INTO THE DECISION PROCESS
The most ualuable cornmodity in the market is inJor-
mation that reduces uncertainty. Traders need to watch
how che market responds ro rcti.vity. If the response is
inconsistent with the manager's information, the man-
ager may want to pursue more research. Thus, trading
cost i,nformation is part of the research thrt gives a
manager relative advantage.
Failure to assess the motivation of the other mar-
ket partrcipants is a primary source of active perfor-
mance trouble. Acti.ve managers often fail to consider
why they are able to trade some stocks easily, whrle orh-
ers simply never get inro che porrfolio.
Exhibit 1 shows that managers and models do
the hard work idendfiTing stocks wirh better-rhan-aver-
age prospects. Talcrng only che easy trades lers the mar-
ket become the "trade-don'r trade" differentiator. Thrs
is running the process backward. Market dynamics
ensure that trades are easiest when the gross research
advantage is most negatrve. Thus, rfte hard trades are orten
the least uncertain, but also the most proftable.
The trader's prioriries musr be primanly ro cap-
ture the vaiue of the best ideas and secondarily to min-
imize cost. Traders who avoid impact ler rhe market
rather than the manager choose rhe bem (see "How
-
-
Tlading Can Distort Invesrmenr Selection" [1993]). No
rrranager knows in advance whrch ideas will be the true
E winners, but letting the opponen[s choose the bets
makes no sense at all.
|
The lesson: Managers must 6.rst measure and
develop confidence in the value of their research, and
then incorporate feedback from che market. Only man-
agers who practice a disciplined implementation
r--"n"ch L.ur
appruaLrr rrn rrrin
wur rh. lino 5--.-,.
Lrrc S,CtIVe mana.gement CfaL,.-b mma
THEJOURNAT OF PORTFOLTO M^NAGEMENT 23
 Thus, we can add a third saying to Peter REFERENCES
Bernstei.n\. Itt not, "A penny saved is a Penny earned,"
because overzealous cost conrrol snufii out ,irty oppor- Arnott,
Robert' "Quantitative lvlanagement: Its Roll .in the
Coming Decade.'' Financial Analysts Jouma!' May-June 1994'
tunities. A better one is "'Tis many a rUp '**J."it*a
|ip." Good execurion is essential to investment success. Bemstein, peter. Speech de|ivered at rhe 6fth Plexus Group
Conference, LPnl 2' 1997 '

ENDNOTES ,,How Trading Can Distort Invesrment Selecrion." Plexus

Grouo. 1993.
"'We eliminate all small "cash" decisiors (less than 20,000
'Wayne H., end Mark Edwards. "lmplementing
shares for large-cap [> 2.5 $bil] and less than 10,000 shares for Wagner,
small-cap [<2.5 $bil]), and equal-weight the remaining decuions. Investmenr Srrateges: The Art and Science of Invesdng." In Frenk
We analyze over 40,000 large-cap decisions and nearly 60,000 J. Fabozzi, ed., Handbook of PortJolio lvlanagemen| New Hope, PA:
small-cap decisioru. FrankJ. Frbozzi Associates, 1998.

SPRINC I999
CAPTURTNC TH-E RESEARCH .\DVANTAGE
24