Portfolio Management and Investment Analysis8

9
Cost Trade-Off
Total cost
Cost Opportunity cost
Execution cost
Time
10
Adverse Selection


Attempting to reduce transaction costs through the use of limit orders can lead to adverse selection – tending to own shares the market dislikes, and to not own shares the market likes. Placing a limit order is equivalent to giving the market a free put or call option (leading to adverse selection problems). There could be opportunity costs.
3
Components of the Bid-Ask Spread


The bid-ask spread in a market-traded security is a transaction cost (and can also be seen as a measure of liquidity). Bid-ask spreads can be modelled as comprising three components:
11
Interaction Between Investment Style and Trading

Investment strategy influences execution and opportunity costs. For example:


Information-motivated and momentum-based trading requires immediate execution: opportunity costs are low, but market impact can be high. Non-information or anti-momentum-based trading can see patient investing that exploits volatility, but might lead to adverse selection problems.


Opportunity costs are equivalent to the theoretical performance of buys and sells that are not executed. Lower actual portfolio performance relative to theoretical portfolio performance may arise from execution costs, but also from opportunity costs. Minimizing execution costs often leads to high opportunity costs. Measuring trade efficiency using (trade price - VWAP) ignores the opportunity costs of non-execution.



Large US-based ‘passive’ micro-cap manager, seeking to exploit superior returns available from micro-cap investments. Trading approach is a key component of their process. By communicating that they are ‘non-information based investors’, they seek to build relationships with other institutions and lessen market impact in their trading. They ‘punish’ bad behaviour by any trading counterparty (e.g. not revealing all known information to DFA; or following a sale to DFA with a series of further sales to the market), by refusing to deal with them for a period of time in future. They also use an in-kind redemption option on their open-ended funds to prevent a ‘death-spiral’ following under-performance. Any lessons for managers in other market segments?

Investment managers may be trading in both ‘styles’ simultaneously – different trading styles might be needed at the same time.
12
Trading Case Study - DFA
4
Implementation Shortfall



Implementation shortfall is the difference between the performance of an actual vs. theoretical portfolio (Perold, 1988). Monitoring and analysis of implementation shortfall can identify the scale of the problem, and the cause: either research-related or implementation-related. Services such as ‘Inalytics’ decompose implementation shortfall into manager timing, trader timing and broker impact effects.
Trading
James Clunie March 2011
1
Introduction




Implementation shortfall Opportunity cost and execution cost Interaction between investment style and trading technique Compliance Measurement Analysis Timing and splitting trades


Information asymmetry costs (it rewards dealers or market-makers for bearing the risk of trading with ‘informed’ traders). See, for example, Glosten and Milgrom (1985). (Fixed) order-processing costs Inventory carrying costs.
5
Implementation Shortfall
Cumulative return (%)
15
Theoretical portfolio
Implementation shortfall
10
5
Actual portfolio
2000
2002 Year
2004
6
Opportunity Costs

7
Market Impact


Trading in securities with low liquidity, or the placing of very large trades in securities with good liquidity, is likely to have some form of market impact. That is to say, the placing of the order will influence the price at which the security is to be traded. There exist several models for estimating market impact of a trade (e.g. Breen, Hodrick and Korajczyk (1999)) To estimate the impact of a particular size of trade, one may consider an electronic exchange which matches bids and offers, or a market-maker driven system, where an intermediary makes two way trades in securities. An example of an ‘idiosynchratic tender’ price impact model is shown on the next page: