Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

V. Trading Performance Measurement

performance assessment. As we have seen, transaction cost measurement attempts to determine the source and magnitude of trading costs. Trading performance assessment, by contrast, looks into the justifications for these costs and seeks to identify any costs caused by poor implementation decisions. In other words, performance evaluation attempts to assess the performance of intermediaries when they execute trades. The ultimate aim is to determine the most effective intermediaries by market, instrument and trading strategy. With this information at hand, investment managers can considerably reduce the time required to select the best intermediary for the execution of a specific trade. Given the above objective, a good trading performancemeasure shouldhelp investors determine if the actual transaction costs incurred were reasonable under the market circumstances that prevailed at the time of the trade. Proper performance evaluation must therefore assess the real capability of intermediaries and, to a larger extent, determine if they add value. Distinguishing between skill and luck can make it possible to determine if execution can indeed be termed best. 2. Current State of the Industry and Practices The most common performance measurement practice in the industry is the benchmark comparison described above. So, here we address its shortcomings as a gauge of trading performance. Next, we will introduce the relative performance measure developed by Kissell and Glantz (2003). Although this measure is not

The last task assigned to TCA is the assessment of trading performance. Like transaction costs, trading performance must be measured after the execution of the trade. Here, it is crucial to understand clearly how evaluation of trading performance differs from transaction cost measurement, although both are done ex post . Even today there is widespread confusion of transaction cost and trading performance measures; this confusion leads to the frequent industry adoption of inappropriate practices. Although the main reason for this ongoing confusion is undoubtedly the elusive and sometimes controversial notion of best execution (we will come back to this important notion), it must be said that some in the industry also contribute to its currency. Some intermediaries, for example, have incentives to argue that trading performance evaluation is extremely complex and that it should be founded on market impact that cannot be observed or measured. They can thus consistently come up with arguments, some more relevant than others, for declaring benchmarks or peer groups unfit for assessing the quality of their trades. In this way, they avoid being subjected to performance assessment. In addition, some consultants have a vested interest in this confusion, since it justifies their lucrative business. In any case, effective transaction cost management would require clarification. 1. Transaction Costs vs. Trading Performance

Post-trade analysis consists of two parts: transaction cost measurement and trading

58

An EDHEC Risk and Asset Management Research Centre Publication