If Best Execution is a Process,
What Does that Process Look
Like?
W,rvhrn H. WhcNER AND M.q,nx EnwaRns
VavNE H. \IecNsR n defining Best Execution for securities
is a senior advisor at iTG trading, the Best Execution Taskforce of
Solutions Nefwork in Los
the CFA Institute (formerly the Associ-
Angeles, CA.
wwagner@itginc.com
ation of Investment Management
Research) was careful to refer to it as a process,
Maxx Envanus not an outcome. To many, this is a disquieting
1s--at defirution, for it does not lead to easy agree-
ITG Soiutioas, Inc., ment. Indeed, some have argued for a simpler
in
---.. definition which, even though krrown to be
Emdl
inferior, is at least objective. lJnfortunately,
this simpler defirution runs the danger of sub-
stituting appearance for realiry.
In fact, the definition for "best execu-
tion" is not that different from the "best
efrorts" definition of prudence. As Einstein
said, "It is important to keep things as simple
as possible. But not more simple."
If we think atrout best execution as a
process, we are inevitably 1ed to the work of
Peter Drucker. Drucker devoted much of his
liG to the issue of productivity in knowledge
and service work and phrased it succinctly:
"The first question in increasing productivity
in knowledge and service work has to be:
What is the task? What do we try to accom-
plish? Why do it at all?" Of course, the ques-
tion of "why do it at all?" takes us back to the
prudency principle that investment ryutnagers
have lived comfortably under for well over a
century; that is, the primacy of the client's
interests.
Whiie the application ofa Drucker-iike
discipline might seem completely obvious, it
SUMMER 2007
is not so long ago that it was rarely forurd in
investment management. A rnore colnmon
portfolio nvrnager rnight have
resporlse frorr_ a
beerr-and in one case actually was-"I pick
stocks. The rest is just plumbing." We are not
likely to hear that response again, for three
reasons:
1. The Securities and Exchange Comrnis-
sion {SEC) considers Best Execution a
part ofthe fiduciary duty ofan invest-
ment manager;
2. As a result, instirudonal and even retail
im/estors are increasingly atnmed to em-
cient, effective investment rnanagement
operations; and,
3. More to the point, ,pplyrt g a process
analyses to the implementation ofinvest-
ment ideas is a proven means ofimproving
investment performance.
Let's take a look at the implementation
of investment ideas, taking a page from the
Drucker viewpoint: In the following sub-
sections, we will identify and discuss these six
steps:
1. Establish goals: What. are we trFng to
achieve, and how wiil we define success?
2. Define the process: Who and what are
involved in the process, and why? We
model the execulion process, then set up
data collection.
T1s IouRl.rAL oF TRADINc I
 3. Analyze the data: As one client asked us "One, two,
three: what are the most important things that I
need to know?" This requires rigorous analysis of
the data, along with relevant benchmarks. As the
investigation progresses, the priorities evolve.
4. Identify solutians: Here's where man€ement plays a
guiding role: What are the stones left untumed?
What are others doing?
5. Implement the solutions: Nothing happens until some-
thing happens; curiously "something happens" fre-
quently occurs without conscious effclrt.
6. Reuiew and reuise: \Jnfortunately, the true answers
may take some time to discover. Nor is the ultimate
solution likely to remain optimal for long
changing investment environment and market evo-
lution. The process is ilot start-to-finish, but a con-
tinuous, looping search for better solutions.
To understand how these parts fit together, we need
to focus on the links in the chain; i.e., the mairr partres
in the production process, specifically, the chiefinvest-
ment otEcer (CIO), the portfolio managers, the head
trader, the buy-side desk traders arrd the brokers. We dis-
cuss the roies that each ofthese parties play, and the inter-
active links befween them.
ESTABLISH GOALS
Besides research and portfolio desigr, trading is a
supporting column to the over-arching goal of invest-
ment rurnagement: capture as much return as possible
from the available objectives, skills, arrd facilities.
One of Drusker's key requirements is that the goal
must be measurable. As Carl Sagan put it, "Remember,
subjective observations are useless to science. Often, the
difference between subjectivity and objectiviry is the abfiry
to count er measure. So, count and measure." This is dif-
ficult to do in the constantly drifting and shifting world
ofinvesting. But clearly, it can be done.
The CIO or chief executive officer (CEO) of the
organization needs tcl take a leading role in the process to
heighten its importance and secure the joint participa-
rion ofall the important parties. Without centralized iead-
ership, the process is likely to degenerate into disconnected
and localized solutions; e.g., trad'ing solutions that ignore
the critical role of portfolio manager interaction.
Investment filanagernent organizations are made up
ofpeople with individual, and collective, skills. Ifthe skills
IF BEsr ExscurroN rs A PRocEss. WHAT DoES TFrAT PRoCESS
are not adequate to the task, the organization must secure
the technological and organizational resources necessary
to perform the complicated set of tasks required to solve
the investment management goal. It also must carefirlly
deploy those resources to maximum e{1-ectiveness. The
CIOt overall perspective is essential to this process.
DEFINE THE PROCESS
During our portfolio rnanagement days, a consul-
tant once asked us to "Define your process. Without a
clear process, your returns are random."
Defining the investment process proved to be a more
in a difiicult task than, say, defining how one manufactures
light bulbs. Iight bulb manufacrirring can be optirnized
by carefully controlling the material inputs, standardizing
the manufacturing processes to avoid undesired variatron,
and continually tracking the product to a$sure that the
system remains within acceptable manufacturing quality
standards. Note that all of these steps require continuous
measurement to attest to objective standards. Vihen these
factors of production have l-ittle variance in them, the
manufacturing failure rate cart be reduced to a small frac-
tion ofone percent.
Investment managers do not f.ive in such a conve-
nient physical cause-and-effect environment where vari-
ability is largeiy responsive to the iaws ofph,vsics. Refurns
are often subject to multiple influences. But the process
that goes into portfolio construction, stock selection, and
execution is still vital in controlling both the portfoliot
characteristics and costs.
Drucker uses the terms "disciplined" and "replic-
able" as ideal characterisfics of a manufacturing process.
fulichael Lewis' Moneyball is a great example of applying
Drucker's world to baseball. By breaking down player
skilis into those that lead to wins, rather than popular
stats, Oakland generai manager Billy Bean has been
able to produce a consistent winner despite the lack of
individual all-stars. In similar fashion, not many invest-
ment operations have a Peter Lynch or a Bill Miller;
consequently, money management firms would ben-
efit from defining, modeling, and measuring all the
aspects of their investing process-stock selection and
implementation.
There are myriad resources available to firms to
help model and manage stock selection. Moreor,'er, it's
relatively easy to identify what, and when, the portfoLio
buys and sells stocks. But modeling the execution
LooK LIKi? SUMMER 2007
process-the link berween the portfolio manager' trader,
and broker-isn't as clear cut. Flowever, with the aid of
data readily available (we say that with slight tongue in
cheek) from Order Management Systems (OIS), the exe-
cution process can be modeled.
More importantly, the eft"ort is worth it. Think in
terms of the batting coach who s'orks with baseball
players who've akeady made it to 'the show.' By con-
stantly analyzing swings, the coaches heip talented athletes
improve their game even more. Above all, the batting
coach demonstrates the advantage of an independent,
objective view with no stake in "things are just fine the
',vay they are."
Now we're ready to follow Sagan's advice to count
arrd measure. The frst step in counting is to record and
retain. 'We are far less interested, 1br example, in whether
the trader thinks the broker did a goodjob on thds trade
than we are about the nuts and bolts ofhow the trade was
accomplished: what, when and why was the trade done?
'We
need to know the followinE details:
1. At what time rvas the trade released to the desk?
2. Was the order complete and executable at that point
in time?
3. What instructions were attached to the trade by the
portfolio manager?
4. Were compliance checks performed? Were there
any flags?
5. To which trader was this trade assigned?
6. Which broker was selected, and why?
7. What were the instructions to the broker?
8. When was the order released to the broker? Ifit was
parceled out over time, when and holv much?
9. \X,tat venues were used, and which algorithms?
10. \X4ren were the pieces executed, and at what price?
11. When was the order completedand/or abandoned?
12. How rn'eil did the idea work out as an investment?
W-ere we able to pay the transaction costs and still
generate satisfactory returns?
13. To which accounts were the traded securities
assigned?
Collecting all this detail sounds like a tail order fbr
an active desk, but most ofthe information is readily avail-
able in a well-tuned Order Management System (OMS),
especially one tightly wired to FIX connections.
In a large shop with multiple fimds, managers and
traders, each ofthe data collection points (orders leading
SUMMER 2007
to trades) above may be not one event but a stream of
events. Thus the amount of inforrnation to be processed
can be quite voluminous for a busy desk.
ANALYZE THE DA?\
Analyzing the data is a complicated, but large$ auto-
mated, task. Some steps that need to be taken are:
1. Check the data for egregious errors; for e.g., incor-
rect trade dates due to cancels/c<,rrrects or incorrect
prices and commjssions.
2. Create a time line rvhich computes the state of the
process at any time that the stafus changes:
a. At every point in time, how much was ordered?
b. F{ow much r.vas released to the trader?
How much was executable bv a trader?
How much was released to the broker?
How much was executed, and how much
outstandins?
3. Embed the time line data in the record of the trading
environment at the time of action to address ques-
tions such as:
a. 'What was the price trend at the time of execution?
b. What:vas the availability of liquidity-the iimit
order book-at the time?
c. Check the data for plausibfiB; for e.g., was the
execution price outside the BBO at the time of
trade? Correct it as necessary.
4. Compute the cost of each individual trade. ffi/e dis-
cuss cost methodologies in a later section.)
5. Contextualize the cost in ternx of a comparative
benchmark that addresses the question: What should
a trade of this nature cost?
6. Store the data in a manner that facilitates aggrega-
tion into meaningfui sub-sets; for e.g.,
a. Controlling party: m:rnager by manager, trader
by trader, broker by broker, market by market
b. Buys vs. selis
c. Order instructions; for e-g., if an aigorithm was
used, which one, and why?
d. Supply/demand imbalance: favorable, neutral or
adverse?
e. Consumption of liquidity; percent ofvolume
f. Company capitalization
Tls TouRNAL oF TturDING 3
 g. Various other standard breakdowns of the trading
universe
h. Combinations of criteria; for e.g., How well did
Broker X do when handling small capitalization
issues?
i. Custom questions that have come up as issues
during prer,-ious analysis cycles; for e.g., a firm
may ask: Do we get better executions on trades
that are actionable before the merrket opens vs.
those issued later in the day? Oa a firm may have
done a massive portfolio restructuring and want
to separate those trades from the routine trading.
Or, a firm might har,'e set up a specific experi-
ment to test a particular algorithmic engine.
Now that the data has been gathered, verified, cal-
ibrated, structured, enriched, measured, and sar,-ed, we
are ready to do the analysis.
IDENTTFY THE PROBLEMS
This is often the hardest step, because inevitabiy
someone in the organization feels that their toes are being
stepped on. Be a\r/are thatit might be a lvhile before the
organization is comfortable with this critical self-analysis.
Flere are some thoughts on how to overcome this
problem:
1. Remind everyone of the goal. Encourage positive
contributions.
2. Remernber the batting coach analogy.
3. Begin by focusing on the positives: the things that
are working well.
4. Focus on the patterns, not the individual outcomes.
Every organization will have some outstanding, as
well as some poor, decisions and implementatrons.
There should be no surprises here; everyone should
remember the sting or the eiation of these outlier
events. This is spilt milk; nothing can be done
about the past and, in all likelihood, anlthing that
could be done to prevent repeats has probably been
done.
5. Focus on the changes: Where are we showing up
better, or worse?
6. Look for the systematic probiems; categories of
activirywhich dont seem to live up to expectations.
Finding 10 basis points of improvement on 1000
trades will help as much as a 1000 basis points on'
-WHAT
IF BEsr ExEcurroN rs A PRocEss- DoEs rFLAT PRoCESS Loor
10 trades, and will be much easier to find ways to
irnprove rhe result
7. Don't worry about solutions as yet. Focus on finding
the problematic situations.
8. Above all, avoid finger pointing! As we will soon see,
the opportunities to improve are likelv to involve
the interaction between multiple parties.
9. Always keep an eye out for cornpliance issues. I lorv
rn'ould this practice look on the front p'age of the
newspaper?
Usinga TCAreport to find opporrunities to improve
the process is fbrensic detective work. It isn't easy at the
start; the reports will he ful1 of rows and columns that
will mean nothing at first. The graphs rvill be unintelli-
gible until you figure out the axes and understand what
thus picture is trying to show. The reports will be designed
to show a colnplete picture; identifying the problems
means finding the anomalies in the report.
So rvhere are the usual suspects? Some questions
that could be addressed are:
1. Where are the biggest problems, such as the highest
costs, or the least value captured?
2. V4rere are we being hit by hidden costs?
3. Where's the low hanging fruit, the quickest route to
performance improvements ?
4. What were the market situations that caused difii-
cult, high-cost trading conditions? How well did
we do?
5. What were our problems in the last go-around?
What solutions did we implement, and do we see
improvement?
PROPOSE SOLUTIONS
There is a danger in trying to solve all the problems
at once. A better strategy is to focus on identi$ing trvo
or three things that can be done, and that wifi be partic-
ularly helpful. It's a good idea to keep a record of these
issues as a reminder to the involved parties. It also looks
good in a compliance repott.
Start with the easy solutions; the 1ow hanging &uit.
It may well turn out that some of the high-cost sir-
uations are unavoidable. For example, if a small-cap
momentum manager insists on dumping stocks after bad
nervs hits, the costs will be significant. There are no easy
answers here; whether the affected stocks are sold or not,
Lx-e? SUMMER 2OO7
perforrnance will be affected. One very aggressrve man-
ager chose to adopt the policy of waiting six weeks to
decide whether the stock should still be held in the port-
folio, and found that it added vaiue by avoiding a panic
sale.
Enc ourage out-of-the-box thinking. tJnless there
is something totally dysf,rnctional in the orgarrization, we
are dealing with an organization that has already derived
a solution for the most eft-ective use of people, perceptions,
comrrnrnications, processes, and technology. If we take
those conditions as unchangeable, we cannot expect to
come to a significantly different solution. The operative
question is "what can be changed to make the process
more effective here?" "Try harder" is not an acceptable
answer.
Make trading intelligence a priority. Keep an open
charurel to nerv ideas from other traders, other rnanagers,
the industry press, and TCA providers.
Ultimatel-v, all efGctive solurions will involr,'e change.
It is the job of the CIO to assure everyone that the orga-
nization executes the changes that enhance the perfor-
mance outcomes.
The proposed solutions should be written down in
the minutes of the meeting, and should be reviewed in
detail when the next reoorts are available.
IMPLEMENT THE SOLUTIONS
All the steps above are all necessary to the process,
but nothing happens until something happens. Keeping
the organization on track to implement the soiutions and
assess their eft-ects is er,'eryone's responsibiliry.
While not incompatible with the compliance
process, Best Execution is about capturing maximal invest-
ment return. The problem is solved top-down, not
bottom-up, from a set of prohibitions and reporting
requirements that can only define a minimal acceptable
level to keep the organization from crossing the line. But
a good compliance oficer builds the guardrails, then lets
the grand-prix individuals exercise their skills unham-
pered by over-zealously applied restrictions.
Having worked with many otgarizatrons to irnprove
execution processes, one curious thing has ah,vays struck
SUMMER 2007
us: often the solution gets adopted without consclous
a\Mareness. A TCA report shows improvement in a crit-
ical area, but congratulations are met with a puzzled "We
didnt do anything differently'' What! going on here?
Professionals, especially traders and athletes, are
accustomed to instant integration ofnew inlbrmation. A
cornerback may get surprised by a receiver's move, and
adjusts without thinking about it. A skier senses the snow
conditions and unconsciously adjusts. A trader hears an
idea and that idea immediatelv becomes his own.
REVIEIry AND REVISE
The final step is to start ail over again:
1. The success of solutions worked out in last cycle
need to be assessed and, ifnecessary, adjusted.
2, Problems ignored in the last quarter may become
candidates for new areas of improvement in this
quarter.
3. New investment opportunities may require adapta-
tion in the way they flow through the organization.
4. New technologies, data, or communication faci-li-
ties may create opportunities to enh;mce effective-
ness in certain situations.
Confession titne: For years clierrts have asked me
whether they can expect to see the results in their per-
formance. Conersely, does TCA harre to be taken l*g"ly
as an article offaith? Except in isolated and usually egre-
gious situations, it is difficult to detect any performance
enhancement. There are simply too many moving parts.
Best Execution processes can take some of the ran-
domness out of the result, and can reduce some of the
slippage that leads to poor performance. But too many
other sources ofvariation are perpetually out ofour con-
trol. We need to take solace in the belief that better
processes will lead to improved results.
To order reprints o-f this article, please contact Dewey Palmiei at
dpalmieri@iij ournals.eam or 2 1 2 - 2 2 4- 3 57 5
THE JouRNAl oF TR ADING 5