Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

I. Transaction Cost Analysis as Part of the Investment Process

must costs proactively, because lower transaction costs mean higher portfolio returns. Ineffective transaction cost management may be very damaging in today's competitive environment, in which the difference between success and failure may be no more than a few basis points, or in which tiny spreads offer arbitrage strategies that must be protected from transaction costs. The aim of transaction cost analysis (TCA) is to provide a scorecard that helps investment managers assess understand how well their decisions have been acted on and how they can improve their overall performance. On the one hand, as different trading strategies correspond to different risk-cost trade- offs, investment managers need to know the real cost of implementing a given trading strategy. On the other hand, since bad execution can impact the total performance of even the best investment decision, investment managers must be able to assess the trading performance of their intermediaries (brokers, traders or even algorithms). Roughly, then, TCA is a tool for monitoring both the transaction costs of trading strategies and the trading performance of intermediaries. Going into greater detail, we can attribute to TCA three distinct and specific tasks: •  Transaction cost measurement •  Transaction cost estimation •  Trading performance assessment It is first very important to understand the difference between cost measurement and cost estimation, because, as we will see, each requires a specific methodology. In a nutshell, transaction cost measurement involves assessing the cost of completed manage transaction

Four distinctive phases are usually identified in the investment decision cycle. They may be summarised as follows. The asset allocation phase refers to the distribution of funds across investment classes (equities, bonds, cash, commodities, derivatives, hedge funds, real estate, etc.) with the objective of diversifying risk and targeting a specified return. The portfolio construction phase is the phase wherein decisions about the exact instruments to buy or sell in each investment class are made. The execution services phase is the phase during which investment decisions are acted on. It involves decisions regarding the trading strategy: where, when and how to buy/ sell. Finally, the portfolio attribution phase involves assessing portfolio performance and analysing reasons for missing the targeted return. Most financial research is devoted to asset allocation, portfolio construction and performance attribution. We do not find the same abundance of literature on the implementation of investment decisions. For the total performance of a portfolio, however, the quality of the implementation is as important as the decision itself. The reason is that the implementation of investment decisions is not free and that the associated costs usually reduce portfolio returns with limited potential to generate upside potential. These costs can turn high-quality investments into moderately profitable investments or low-quality investments into unprofitable investments. These costs are usually referred to as transaction costs.

To provide investors with competitive portfolio returns, investment managers

10 An EDHEC Risk and Asset Management Research Centre Publication

Made with FlippingBook flipbook maker