Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

Introduction

•  define a new and complete approach wherein checking whether best execution is achieved lies in the entire transaction cost management process. To cover all the aspects related to these objectives, we have structured the present work in six sections. Section I provides insights into how transaction costs arise during the investment cycle as well as an introduction to TCA’s main goals. After a brief description of the investment phases, we first highlight the importance of being proactive in managing transaction costs to obtain competitive returns. We then present TCA as a very valuable decision-making tool since it allows monitoring both the transaction costs of different implementation strategies and the trading performance of different intermediaries. At this stage, we briefly introduce the three TCA missions— transaction cost measurement, transaction cost estimation and trading performance assessment . We conclude by showing how TCA can effectively contribute to enhancing total portfolio performance. Section II provides a thorough investigation into transaction cost components and drivers. Transaction costs include all costs associated with trading, which are usually divided into explicit and implicit costs. Explicit costs include brokerage commissions, market fees, clearing and settlement costs, and taxes/stamp duties. These costs do not rely on the trading strategy and can be quite easily determined before the execution of the trade. By contrast, implicit costs represent the invisible part of transaction costs and consist of

spread, market impact and opportunity costs. As variable components, they offer the opportunity to improve the quality of execution. This section reviews all the costs of both categories in detail and gives insights into why they arise when investment decisions are made. In addition, we provide empirical evidence of the differences in total transaction costs as well as their composition across regions and trading venues, in Europe in particular. Section III is devoted to the two fundamental approaches to measuring transaction costs. Benchmark comparison measures the cost of trading by the signed difference between the trade price and a specified benchmark price. This method provides cost indicators that depend on whether they are built on pre-trade, intraday or post-trade benchmarks. Implementation shortfall defines the cost of trading as the difference between the actual portfolio return and its paper return benchmark. This approach has become the standard for transaction cost measurement and we document how the primary framework may be expanded to fine-tune cost identification. Before reviewing the most popular indicators used in the industry, we emphasise several issues to consider when measuring costs. We conclude with new practical questions and complications that emerge with MiFID. Section IV deals with pre-trade analysis, whose primary purpose is to forecast both the transaction costs and the risks associated with various strategies for a given trade or a specific trade list not yet executed. In this section we refer to the approach developed by Kissell and Glantz (2003) and show that it makes it possible to determine

7 An EDHEC Risk and Asset Management Research Centre Publication