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COMMENTARY 75 APRIL 2OO3

HANDICAPS AND HANDCUFFS

Among the thousands of numbers calculated in a typical Plexus report, the one that usually
deserves the most attention is the "value added" by the trade desk (trading costs minus
PAEG/L) This number indicates whether a firm's trading is more or less'efficient than trading
by other firms with similar orders.

But not all trade desks play on a level playing field. Every trading desk is unique in its own
way. Some firms have a relatively straight-forward process wheie managers decide which
stocks to buy and sell, then enter the orders into their OMS, giving the traders full discretion
to trade. But in most cases, traders face limitations and instructions that significantly
complicate their job, and iikely increase trading costs.

In this commentary, we evaluate the various handicaps and handcuffs that traders face and
their likely impact on value added. Specifically, we discuss, quantify, and elaborate on prior
research regarding how directed commissions, soft dollars, cash matched (or pairs) trailing,
firm location & order times, and firm size affect the trade desk's abilitv to bbat their PAEGIL
benchmark.

We then pre_sent our findings on how manager limits affect the desk's ability to achieve best
execution. Each of these barriers has a cost; once recognized, it is up- to each firm to
carefully weigh the costs versus the expected benefits, communicate their'findings internally
and with their clients where appropriate, and adjust their process accordingly.

A "Handicap" is defined by Merriam-Webster as "a We know from securities analysis that every
disadvantage that makes achievement unusually option has a value that can be estimated. For
difficult." From another perspective, in the game instance, equity option valuations can be
of golf, the probability is that a player with a low estimated with the Black-Scholes model.
handicap is going to shoot lower scores than a Similarly, we would suggest that to a trader,
player with a high handicap. Likewise, in options to trade have value. For instance, the
institutional trading we can also count on the option to trade with any broker should have value
likelihocd that a trading desk encurnbered by over the instruction to traCe with only brcker XYZ.
trading restrictions is likely to have higher relative Likewise, the choice of when to trade (rather than
costs than trading desks that don't. being forced to trade immediately or to wait)
should in theory have some value.
In an attempt to put trading desks on an even
playing field, we identify and quantify the primary The cost of a trading restriction can be viewed as
trading differences that handicap trading desks. equal to the value of the lost option of the
First we summarize prior research (by Plexus, as alternatives. So by determining the difference
well as independent academics using Plexus between an unencumbered trading desk and a
Client data) where trading disadvantages hdve handicapped or handcuffed trade desk, we can
been documented, and then we present place a value on the restrictions. The value of a
additional findings and theory about other trading trading restriction reflects the tradeoffs of time,
restrictions. potentially adverse price moves (volatility), and
the resulting returns.
 Cash Matched & Pairs Trading
Direction
71' "What Do
handicap we review is "Directed" As documented in our Commentary
The first trading
to The Good Desks Do?",
we found that cash
tradtng, whereby a client instructs a manager tends to disadvantage Y
in iheir account to a specific broker matching and pairs trading
Jirect-tiaOes the tradl desk. Generally, cash matched firms
(recapturing commissions in the process)' Rather generate the-
venues or brokers' the must complete their sells in order to
ihan'using their regular Therefore the option of
must use the specified broker' The fasfr to pay for the buys'
traders have been eliminated
be buying immediately may
potential problem is that those brokers may not sells may have added pressure to get
the liquidity available to other uni tf'"
able to access be initiated' The
plain traded quickly .o ih" buys could
brokers. For some types of trades (like value lost by cash matched trades was -30
bps'
trades) there may be little
vanilla or value-oriented
Pairs trading is particularly expensive because
ornocost,butforothertrades(likeilliquid be specific tradLs must coincide
with each other'
momentum-oriented trades) the cost may to buy' it's a lousy
Thus far, Plexus has documented the Usuatty, when it's a good time
substantial. But you don't usually
in time to sell and vice versa'
costs of Directed trading twice, most recently compensaie for ihe extra
57, "Directed Brokerage: No save enougi-r on one io
o-i- Commentary
found cost on thL other. A
good analogy is in long
that study' we
Free Lunch - Revisited"' In
trades distance running; you don't
make up enough time
that on a PAEG/L adjusted basis, Directed time on the
by bps' Plus' the on the downhill to compensate for lost
iugg"O Non-Directed trades -26
OlrJcted trades had weaker returns than
the Non- uphill.
Directed trades by an average of 33 bps' and Order Times
Firm Location
On
ln our Commentary 69, "Time Of Day Effects
Soff Dollars Trading Costs,,, we discussed order times
and their
Jn trading costs and varue added' The theory
with soft dorar rerationships, traders use specific Sjrect
is inat orders praceo after the open can
place the
brokers in order to generate to
commissions
doilar obrigations. ir
nguin, il traders at a drsadvantage because a significant
the firm,s soft lt
satisfy
using the of
broker percentage of trading occurs at or near the open'
is a case when rather than
becomes more difficult to camouflage an
illiquid
uses one or more r"tt
rp"riti"J
order when trading is initiated after the open'
choice, the trader
dorar brokers. The cost again is the of
rost option the open
oi trading ;;#r. In Absorute trading costs for orders after
using other brokers higher than pre-open order
,,rnstitutionar rrading and soft Doilars" conrad, *"r" ror" than 30 bps
Johnson,andWaha|documented(usingcosts'u:::,:|T'"'',afteropenordersWere
roughiy 'lu bps more expenslve than
pre-open
disguiseo plexus client data) economicaliy orders'
costs from using soft doilar brokers'
meaningful
just
benefits of Foilowing up on that research when we look at
of course, the costs are offset by the crients hLadquartered in Pacific standard
Time
the soft-dorar brokerage (whether in the form of were
recapture, or third party cities we find that: [1] the west coast firms
research, commission
stiil, the authors estimated that more rikery to have a smaller than average
reimbursement). (17%
the benefit (with percentage of orders praced prior to the open
the incrementar costs exceeded the gap
consistent with ou.. versus [a% to, the full sample) and [2]
a **%reimbursement rate).
to soft versus on pre- and pOSt-Open orders was
theory, we can estimate an overa, cost may
il.," rarger than in the full sample' In other words' it
'AEG/L
dorar brokerage in the form of 'ih; -;;;r";"
"ii*."ii"g nelmportant for west coast Portfolio Managers
to
option of using better brokers.
given the apparent location
incrementar cost in the study was -29 np,
i"inrvs be earry risers perspective)'
disadvantage (at reist from the trade
and _24bps for sers.
 change them, thus incurring opportunity costs
Firm Size ($ Turnover) rather than high trading costs when the stock
prices move away. Other managers will change
Also included in our Commentary 71, was a
the limits after the stocks have moved away,
discussion of size in terms of dollars traded per
quarter. Firms trading under $4.5 billion per leading to higher time delay costs. With
limits, it is
short-sighted to focus solely on value added since
quarter had Value Added by the trade desk 7 bps
the adverse effects often manifest in other areas
better than firms trading more than $4.5 billion per
(weak returns and/or opportunity costs). Yet, we
quarter. Additionally, the top ten largest firms were
can make some conclusions and generalizations
another 4 bps weaker versus PAEG/L than the
about the results we see for limits.
sample of large (high turnover) firms, or '11 bps
weaker than the small firms.
The sample of clients using limits is a diversified
group including both large and small cap
The theory explaining this relationship is that
managers. On average, the limits accounted for
large firms havegreater liquidity demands and
8.5% of the firms'dollars traded. Several had 15%
therefore sometimes orefer to complete trades
or more of their order flow saddled with limits,
sooner when a contra is identified, while smaller
while othei's had limits reoresentinc 1o,/" of their
firms may be more cost conscious and may
dollars traded.
choose to wait. In other words, when liquidity is
available, the larger firms often waive their option
Overall, limits generally occur on orders with
to trade at a later time even if the cost is higher
stronger returns than non-limit orders. Of course,
than they expect. The evidence shows that large
the main objective of placing a limit is to prevent
firms tend to have lower value added when
high costs and consistent with that, the majority of
providing liquidity. Large firms seem to forgo
firms using limits had lower trading costs versus
concessions to capture liquidity.
PAEG/L on the limit orders. But the primary finding
is that B of the 15 had drarnatically higher
Limits opportunity costs on their lirnit orders leading to
weaker portfolio returns than they would have had
Many firms allow their managers to include either without using limits. The remaining 7 had similar
explicit or "soft" price limits with their orders. Soft potential returns for traded and unexecuted
limits are rarely documented and therefore difficult returns resulting in less damaging results.
to identify and measure, but we currently measure
actual hard limits (recorded in the OMS) for '15 In terms of overall conclusions, the results with
domestic money manager clients. There are other limits are not completely cut and dry. We found too
types of order instructions that some of our clients little evidence to recommend changes to only
use and they may be topics of future research three of the iifteen iirms. t'et with over haif of the
(i.e., oh of volume limits, share limits, temporary firms, we did see evidence that the limits were
holds, and cancels). counterproductive. Either the firm ended up
missing out on good trades, or the temporary
Some firms use limits differently, giving rise to limits were eventually lifted or changed and their
some variation in comparability. For instance, trading costs were higher in the end.
some managers place hard limits and don't

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 Trading Handicap Summary
Trading Handicap Expected Additional Gost
Pairs Trading -30 bps
Cash Matching
Soft Dollars -29 bps on buys
-24 bos on sells
Direction -26 bps
After Open Orders 10 bps
Desk Size (Higher turnover) -7 to -11 bps
Price Limits & Cancels Opportunity costs
Short Sale Higher trading cost
Although most discussions of trading efficiency
focus on a firm's trade costs versus PAEG/L, the
preceding information can be used to justify
higher than PAEGiL costs for trading desks
bridled with trading handicaps. Of course, the flip
side is that firms with little or no trading handicaps
should be expected to beat PAEGiL since the
Plexus Universe includes firms that have these
restrictions.
What we recommend for clients that use limits
(and/or the handicaps listed above), is to ask
Piexus to analyze their returns and costs
(including opportunity) to determine the explicit
and inrplicit cosis. iv'iarragers using iirnits need io
know when their instructions are counter-
productive to their own (and their clients)
performance.
With each of the conditions we've listed, there is a
rationale for their existence and a desired benefit.
That benefit needs to be carefully weighed
against the cost to determine whether the tradeoff
is worthwhile. Direction, soft dollars, cash
matching, limits, etc., are usually beyond any
control of the trade desk, but the costs still should
to be communicated to the appropriate decision
makers.
Benefit
Compatible with quantitative strategies
May be conducive to basket/program
trades
Soft dollars payments for research and/or
other services
Client recaptures some commissions
Additional pricing information available.
PMs can sleep later
More assets usually equals more profit
for firm
Limited tradino costs
Creates market neutral and downside
protection options
We haven't conclusively proven our theory that
handicaps and handcuffs placed on traders have
a cost that is equal to the value of the eliminated
trading option, but certainly the research to date
shows a clear pattern of generally consistent
handicapping costs (-10 to -30 bps). Our belief is
that there really is value in allowing traders full
discretion in terms of both choosing the liquidity
sources and the timing of each individual trade.
Only when the traders control both of these
factors can the trader's skill be fullv utilized.
"Revisiting Directed Brokerage: Still No Free Lunch", Plexus Group,
December 1 998. (http://www.plexusgroup.com/commentaries/COMM-
57.odfl
J. Conrad, K. Johnson, and S. Wahal, "lnstitutional Trading and Soft
Dollars", Journal of Finance, February 2001.
( http //www. b u s. e m o ry, ed u/swa h a l/3 97-4 1 6. pdfl
:
"What Do The Good Desks Do?" Plexus Group. Julv 2002
(http://www.plexusgroup.com/commentaries/commentary71 pdf) .
"Time Of Day Effects On Trading Costs", Plexus Group, January 2002.
(http://www.plexusgroup.com/commentaries/commentary69. pdf)
Reprinit any portion with credit given to;
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