Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

V. Trading Performance Measurement

)RPM j (d) RPM vs. VWAP The RPM is somewhat similar to VWAP- based measures since both properly accountfortheprevailingmarketconditions by comparing the average execution price and all other contemporaneous market activity. In that sense, both measures suffer from the same shortcoming. When an order accounts for the main part of market activity in the actual trading period, its average execution price converges to the VWAP computed over that period and the RPM converges to 50%, suggesting average performance. In this case, interpreting these results becomes quite hard since the execution being analysed is its own reference. The main advantage of the RPM over any VWAP-based indicators is, as already mentioned, that the RPM is more robust because it allows multiple comparisons, i.e. , across securities and in the same It is easy to see that, when traders follow the prescribed strategy, the value-added is zero. When they deviate, a positive value- added indicates good market timing ability (the trader achieves better prices and lower costs) and, by contrast, a negative value- added means poor market timing ability (the trader achieves worse prices and higher costs). The VA metric thus assesses the real capability of intermediaries and contributes to distinguishing between skill and luck. A step further is to assess the overall contribution to cost attributable to the trader’s market timing. This could be done by plotting together on a chart the normalised difference between the actual and the expected transaction costs and the VA of the trader.

instructions or constraints set by the investor (on purpose or not), the final result may be higher or lower total transaction costs. In such situations, what is important beyond the RPM is to determine whether the trader’s decision has added value (lower costs) or hurt overall performance (higher costs). Let us take an example to illustrate this concern. Suppose a trader who is requested to execute a given order before midday but decides (for whatever reason) to work it through the entire day. Although he minimises market impact cost, the investor incurs higher total transaction costs because of adverse price movement. It is possible for the trader to get a favourable RPM but it will not give any insight into the effect of his decision on final performance. To address this issue and quantify the value-added by the trader’s own market timing, Kissell and Glantz (2003) define a new metric (VA) to calculate the percentage of the total RPM attributable to the deviation decision, that is: VA = RPM( x * ) − RPM( x ) RPM( x * ) = ( x j j ∑

30 - For periods where x j =0, the RMP j is computed assuming that the trader achieves the average price in the period.

* − x j

RPM( x * )

j ∑

( x

j * − x

)RPM

j

j

RPM( x * ) − RPM( x ) RPM( x * )

,

VA =

=

RPM( x * )

where RPM(x) is the RPM that the trader would have got had he followed investor instructions/constraints and RPM(x*) is his actual RPM. 30 So, by comparing the deviation in strategy, we can assess the value that the market timing of the trader adds to the implementation.

63 An EDHEC Risk and Asset Management Research Centre Publication