Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

V. Trading Performance Measurement

(1) Best execution, this elusive concept

security across days or periods. This is due to the consistency of the RPM, which makes comparison easy. A performance of 75% means exactly the same thing whatever the day, the security or even the trader. Furthermore, unlike the RPM, the VWAP exhibits an asymmetric distribution since most market activity is likely to be on one side of the VWAP. This means that 50% of prices and volume are not higher or lower than the VWAP. We can thus observe situations in which intermediaries underperformed the VWAP but still outperformed the majority of market activity. In those cases, the VWAP scores may lend themselves to misleading interpretations. The absence of a standardised framework for easy assessment of tradingperformance becomes problematic with the arrival of the MiFID. Indeed, with this new piece of European regulation, investment firms are going to enter an environment where they will have to demonstrate that they have executed at the best possible conditions for their clients while taking into consideration potential multiple liquidity pools. To address this issue, we will first focus on the concept of best execution in general. We will see that nowadays this concept is very fashionable in the industry, although it is not always well understood and does mean not the same thing to everyone. Then, we will move on to the MiFID best execution obligation and show that the regulator has provided neither a clear definition nor a measurable objective to make up for the current absence of consensus in the industry. 3. Regulatory Pressure: MiFID and its Best Execution Obligation

Best execution means many things for many people, but everybody agrees that it includes at least trading performance assessment. In theory, best execution is often defined as a measure of how well investors’ trades are executed. This definition is vague as it encompasses components such as the trade price, the execution speed, the opportunity for price improvement, the probability of full execution, the respect of anonymity and the level of explicit costs. Although the total charges paid by the investor are still the main dimension, the others are not to be ignored. Everyone admits that the lowest transaction cost does not necessarily imply best execution, but the consideration of all components intensifies debate when it comes to checking whether best execution has been achieved, essentially because some of these components are not easy to measure and/or combine. Either the information is not directly available (execution speed, price improvement) or the component itself is not measurable (anonymity is respected). According to Kissell and Glantz (2003), best execution can be categorised as price, time, and size factors whose importance varies with the goals and objectives of investors. For example, value and passive investors are concerned mainly with price factors, growth and momentum investors focus on time factors, while large investors and mutual funds pay special attention to size factors. In this respect, Kissell and Glantz (2003) define best execution as “the whole process of managing transaction costs

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An EDHEC Risk and Asset Management Research Centre Publication