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Perf ormernce

COMMENTARY 77 JULY 2OO3

RESEA RCH: HOW ARE PAEG/L@S FORMED?

Market discipline and regulatory pressure are forcing traders to evaluate the quality of their
trading. This can be done by peer group comparisons or against a cost benchmark,
preferably both. As the benchmark becomes more relevant to trade evaluations, traders
want to know what's behind the PAEG/L concept applied by Plexus since 1994. This
Commentary discuss the benchmarking process in detail.

accu rately attributed

Why Did Plexus Create
;

2. Managers and traders develop a better sense

The PAEG/L Concept? of when and why trading costs rise; and
3. Valuable insights lead to action items that
PAEG/L - Plexus Average Execution Gain/Loss - directly enhance future pedormance.
is a benchmark for evaluating the quality of
execution of a trade. The Alpha Capture@ Without a good benchmark, organizations often
implementation shortfall approach answers the cannot make the critical first leap from
ouestion: What did it cost to execute this trade? measurement to evaluation that leads to
The PAEG/I- puts this cost measuring in context improvement.
by answering the question "What should it cost to
execute this trade?"
Sfafisfrcally Speaking, What Is the
"What should it cost?" refers to the
typical Goal of PAEG/L Research?
experience of professional investment managers,
traders, and brokers executing simtlar trades in
si milar circumstances. The objective of PAEG/L research is to explain the
variation in trade cost. This requires:
The PA.trGi! r'neasrrre of eynacted coqt i-e d45ir.rarl
from a statistical regression applied to recent 1. A rich database of observations, consisting of
trade data. Plexus' unique database contains a the experienced costs (the dependent variable)
very large sample of manager-to-trader-to-broker and a variety of potential causative factors;
linked trade data and provides the ability to create 2. A high-power regression package, capable of
intelligent estimates of costs through time. running very large problems;
3. A test-bed facility to determine not only how
Why fs lhr's Important? well we can explain the variation within the
sample (explanatory power) and more
A good benchmark signals whether actual importantly, the ability to explain costs in out-of-
transaction costs reflect good or
poor sample, ntothe-futu re appl ications (forecasti n g
i

performance by managers, traders, and brokers. power);

The benefits of better benchmarks include: 4. A deep understanding of the economics of
trading and the vagaries of trading data.
1. Trading and brokerage skills are more
 quarterly to reflect evolving market structure
How Do You Select
and conditions;
Explanatory Factors? 3. Art as well as science is reouired. The
regression equations are carefully screened
An appropriate benchmark should take into
for outlier observation effects that can easily
account trade- and stock-specific factors. For
distort the equations. An example: a very
example, it should reflect the fact that more large trade that fortuitously found the other
difficult trades such as large trades usually cost
side for a cross al near-zero cost. lt would be
more than small trades. A regression-based
unfair to expect a trader to duplicate those
approach, such as PAEG/L, permits us to try
circumstances, so these irreproducible
various combinations of variables to see what
observations are d iscarded ;
works best as a forecaster.
4. A parallel procedure is used to calculate
Broker PAEG/Ls, which benchmark costs
Every trade is different and traders assess many
from broker release through execution based
factors as they work trades. Defining an on the most recent quarter's data.
exhaustive list of variables and conditions that
capture ihe fuii essence of trading is impossible.
The trick is to identify a set of factors that What Are The Strengths
account for as much of the variability in trade
Of The Database?
cost as possible. Finding these factors is a trial-
and-error process. The modeling process is
Probably the greatest strength is the diversity of
quite similar in scope and in accuracy to what a
sample trades. The sample runs the gamut of
research director would go through while institutional trading from the simplest to the most
developing a stock valuation model.
comolex. lt includes trades from hundreds of
managers, traders, and brokers, all striving to
Over the past fifteen years, we have identified
produce "best execution" and maximal
and tested dozens of factors in combination, performance. lt is an unbiased, peer-based total-
including various measures of liquidity, volatility,
cost comparative standard.
trend, market, size, and nature of the trading
desk (size, style, etc.) We often find, sometimes
much to our surprise, that important-sounding
The second strength is the number of
observations: over a million orders go into the
factors do not add forecasting power. This
computation of U.S. PAEG/Ls each quarter, and
happens when one of the existing factors is a
over 300,000 orders are used in the computation
strong surrogate for another and, so to speak,
of non-U.S. equations. Each observation contains
steals its thunder. For example, tagging trades +lr^ .l^+^
(lcll,cl +^
((J Im^^^!rra aaa*a f.^* -r .- -rr-ti-
^^:^+ r! \Jr
tl l(' llEdDUlY tJtJ>l,D ll t/r | | PUil Pvr !rvllv
according to manager style (e.9. growth, value)
manager inception through all partial completions.
doesn't help because the trade size, company
capitalization and short-term price momentum
Finally, we go to extraordinary efforts to scrub the
already capture the differences between data to avoid the GIGO principle. We estimate
manager styles.
that we spend 2-4 man-years per quarter
validating the data submitted to us.
How Are The Equations Produced?

PAEG/Ls are derived quarterly through a multi.

step process:
1. Measure total transaction cost from time-
stamped manager order through completion;
2. Form a rolling six month client data universe
for trades world-wide. Equations are updated
 What Does a Typical PAEG/L Equation Look Like?

Co- Standard
Factor Interpretation T-test
efficient Error
Absent any other factor effects, transacting is expected to -24.5
Intercept -62.39 2.54
lead to costs.
Market buy/sell balance effect, measured as the product of
MomSize -4.23 0.023 182.0
the size of the trade and the two dav price momentum.
Liquidity demand, measured by the percentage of daily -29.4
PercVol -0.53 0.0'18
volume this trade reDresents.
Size Size of the trade. in shares. 0040622 0.0000030 -20.6
LogCap Log of the Capitalization of the company 8.29 0.61 13.6
A small-trade dummy factor equal to 1 if the trade is under
SizeDummy 17.i3 0.99 17.4
10.000 shares

The PAEG/L equation is estimated separately for The T-Test column shows that all factors are
!.1' qrr rrc call nrr.{nr^ ih li.:+4/.1 qtanlzc onr{ hr rrr trc eall significent at the 99%+ !eve!. l-lcv;ever, the
orders in NASDAQ stocks. The equation above explanatory power is dominated by the MomSize
is the Buy/listed equation applied to the fourth factor, which reflects the compounded effect of
quarter of 2004. A parallel set of equations trading Iarge orders into strongly favorable or
evaluates broker executions. In addition, we adverse market conditions. This is the situation in
calculate separate PAEG/L equations each which trades are most likelv to be costlv.
quarter for Canada. Latin America, Europe (ex-
UK), UK, Emerging Europe, Japan, Asia (ex- Is the Equation Statistically
Japan), and Emerging Asia, Significant?
P/ease lnterpret
The table below compares the in-sample
The Factors For Me explanatory power of the equations developed on
. The Intercept is negative: in the absence of any second and third ouarter 2002 data to the
other factors. the expectation is that transacting predictive power as applied in the fourth quarter,
will lead to costs. 2002.
. MomSize captures the movement of the stock
In-Sample Next Quarter
and provides a measure of the degree to which PAEG/L equation
Explanatory Power Forecasting Power
the trade is liquidity demanding or supplying.
Rising orices during a buy execution is an ru/v "09'i4
adverse situation, so the coefficient should be
negative.
Listed Stocks - Sells 1 130 .0848
Percent Volume is a measure of relative trade
size. We exoect that it will be more difficult to NASDAQ Stocks -
find the other side of the trade for high levels of .1202 091 3
Buys
PercVol, so its coefficient should be negative.
NASDAQ Stocks -
Large orders are more difficult to transact and .1236 0778
Sells
should imply higher costs, so the Size
coefficient is also expected to be negative. Remember that the equation is tuned for
Log Cap is a proxy for stock liquidity, so it is maximum forecasting power (the second
expected that it should have a positive column.) We can easily come up with better R-
coefficient. squareds for the in-sample model, but the power
Trades less than 10,000 shares are easier to derives from over-fitting and is spurious. For the
execute, so we would also expect a positive four equations above, the deterioration as we
coefficient for the Small Trade Dummv factor. move out of sample is about 25%.
 Can We Trust PAEG/L?
What's the Quality of the Estimate?
Absolutely YES, but it is important to understand
what the PAEG/L is telling you. lVarkets, in the
classic understatement. fluctuate. which means
the costs we are trying to explain vary strongly
from day to day depending on market conditions.
The PAEG/L is subject to the same rules as any
statistical analysis. Therefore, the statistic carries
more weight when there are more trades to
reference. We always highlight and recommend
to clients that they should be skeptical about any
statistic.
Can I Have Access
to the PAEG/L equations?
Yes. Ask your consultant to discuss them with
you. Our research is open to clients and we
encourage independent testing and review of our
equations.
How Do I Use PAEG/Ls in a Predictive
Environment Such as TransPort@?
The conundrum of prediction is that today we
don't know tomorrow's market environment" lf the
market rises, sells will be cheap and buys will be
more expensive; vice versa if the market falls.
Our method for dealing with that uncertainty is to
build a Monte Carlo distribution of possible costs
by computing the benchmark cost for each of the
last 100 days. Buys will be more expensive on
rising days and cheaper on falling days. The
distribution shows managers and traders the
range of possible outcomes in tomorrow's
markets.
Of course, when we know the market conditionq
after the fact, we can make the appropriate
adjustment and hone in the estimate.
What's the future of PAEGIL?
Research is a continuing challenge and we
always welcome new ideas and new
technologies. We've hired the best academicians
we can find to come up with better forecasting
power. What we use now is the best result to
date. lt is not, and never will be, the final answer.
Where Can I Go
for More Information?
Check out the Co m me nta ries on
www"plexusgroup,com particularly the one entitled
"A Look Under the Hood of U.S. PAEG/Ls."
Plexus Neurs
Plexus Group's Ninth conference will be held September 21-
24, 2003 at Silverado Country Club & Resod located in
Napa Valley, California. Please look for the program and all
reseruation forms on our website at: www.plexusgroup.com
Plexus canferences gather together managers, traders,
brokers, exchanges and regulators in a format of open
interchange af ideas on markets, trading and investment
performance. This year's conference will feature an updated
format, enhancing the take-away value for the pafticipants.
Re/ease 2.0 of our lceBreaker'drill-down'tool, and a new
on-line application for reviewing daily trading activity will be
available mid-August. More detailed descriptions and
instructions will be communicated very soon, or contact your
consultant to qet the latest infarmation.
Reprint any portion with credit given to:
lexrr
Dlexrrsgrorrp
11150 W. Olympic Blvd., #9AA Los Angeles, CA90064
PH: 31 0.312.5505 FAX: 31 0.31 2.5506
www.plexusgroup.com
Plexus Group is a wholly owned subsidiary of JPMorgan
lnvestor Services Company, a division of JPMorgan Chase.
@ 2Affi Pbxus Group, lnc.