This is Part Two of a Three Part Series
In this second blog on trade rotation, we ask the question…”Does it makes sense to overcome the barriers and eliminate trade rotation?”
Step One: Examine your specific situation. This is a classic cost versus benefit analysis.
- Do your trades take minutes, hours or days?
- Do you notice a difference between execution venues?
- Do you pay commissions to brokers that provide research?
- Do you have performance differences among your accounts?
Step Two: Quantifying the Costs
Market Impact, Information Leakage and Opportunity Costs: As we all know, liquidity characteristics drive trading costs. While S&P500 stocks trade like water, small and mid-cap stocks can be extremely difficult to trade. According to a leading TCA vendor, the average cost of an institutional order is -19.3 bps from Arrival Price. Assuming linear impact, the last fill will be ~38 bps worse than the first fill. These numbers quickly increase as liquidity needs increase. In a rotation format, the last challenge is to give everyone an equal opportunity to feel the pain of going last.
Execution Venues: Using the same data source, while the median execution venue is at -19.3 bps, the 25th percentile is at -0.75 bps and the 75th percentile is at -37.1 bps. Inferior execution venues can easily add 20 bps to your trading cost. We all know that most fixed income managers trade away in order to take advantage of unique execution capabilities. Should the same logic be applied to SMID stocks?
Research Inputs: This is a fairness question as much as a cost issue. If you pay commissions to brokers that provide research, what is the total cost of research commissions relative to those clients that pay commissions. If your “zero-commission” clients participated in the acquisition of research, could you reduce commissions across the board or increase the quality of your research inputs?
Performance: Is there a clear difference in performance among similar accounts?
Commissions: As mentioned, trading away generally results in commission costs being borne by the wrap/custodial client. Based on the data source referenced above, the average commission cost is 5.2 bps on traded value. Your turnover and your rate structure should be used to estimate the extra cost of trading away for your wrap/custodial clients vs. the disparity among execution prices of like securities traded in a rotation.
In Part Three of this Three-Part series, we will look at how others have eliminated trade rotation and how CAPIS may be able to help.
Comments on this series are appreciated as we hope to prompt discussion within this group of practitioners and experts.