capturing the research advantage

8/14/2019 Capturing the Research Advantage

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Capturing theResearch AdvantageInforrnation reduces uncertainty, but good exeottion isMark Edrvards and-Wayne H. Wagner

IvIARK EDWARDS rs drrector o[the Plexus Group in Los Angeles(cA e0064).WAYNE H. WAGNER is chair-mrn of the Plexus Group rn LosAngeles.

1 8 CAPTUR]NG THI, RESEARCH,\DVAN'f AGE

essential to investrnent success.

Berween the ideaA -,.1 ,L- --^l;-,ulu rr.v r!|lsL'Berween the mononAnd the actFalls the Shadow

- T.S. Elioc, "The Hollow Men"eter Bernstein [1997] cites rwo *adagescaptLrre the major lessons of capital martheory: "Nothing ventured, nothing gaineand "Don't put ali your eggs in one baskeThe market rewards risk-cakers for invesung in unctain sicuations, and diversificasion spreads the risk

avoid disasters.What is the risk that Bernscein refers to? Capmarket marhemaricians equate risk with statistical vaabiliry. At best, this is an after-che-fact solurion tbetbre-the-fact problem. Robert Arnott [199a]conuast adopts a more psychological vielv: "Il isn't rif rt isn't unconfortable." Uncertainry about future ocomes creates discomfort, and dealing with dtscomand r.mpertect information is the essence of rcdinvesrment managemenc. If the market conlLrms a desion, uncertai.nry is reduced. The decisions are thtimely - but potenrially expensive - to impl.emenIMPACT OF COMIVIISSIONREDUCTION ON RISK

Exhibits 1 and 2 summarize a srudy of potenSPRING


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EXHIBIT 1COSTLESS RETIIRNS FROMSECTIzuTY SELECTION

6-Wk. Decisron Retum- Absolute +5.47% -2.21%6-Wk. Decision Retum- Market-Adjusted. +3.28% 4J2%

effective stock selecrion.The first impulse of concerned managers is toidentiflz excessive execution costs as the source of per-formance leakage. Sponsors and regulators have 3umpedon this bandwagon, pressing managers, brokers, andexchanges to lower commissions and intraday impact.ln response, desks have mrnrmrzed these direct costs towhere they now account for only 20% of the totalshorrfall. Yet che performance gap persists.TFIE "ICEBERG'' CFIARACTERISTIC OFTOTAL TRANSACTION COSTS

The visible and hidden costs of trading resemblean iceberg. Ac the "tip of che iceberg" iie commissions- the smallest component. In order of increasingobscuriry - but no iess punishing - lie rntraday bro-ker impact, interday tinring delays, and opportururycosts due to missed trades. 'We represent this' idea inExhibit 3.Exhibit 4 decomposes the total shortfall (the ice-berg) for this study. The first column of numbers showsexperienced costs for the traded/untraded shares.Multiplying the raw numbers times the completion rategives the weighted contribution to total cost.When traders and managers recoil from deci-sions due to high commission and impact costs, cap-tured returns drop as a direct result. In fact, the costshave not been avoided, buc merely slufted to the moreinsidious cost categories of delay and opporrunity (theshaded components in Exhibit 5).

Commissions account for only 5% and brokerimpact only 14% of cotal implementation costs.Togerher, delay and opporrurury costs accounc for more

EXHIBIT 3IMPLEMENTATION COST "ICEBERG"

Buys SeilsRound-TripI Hrrlrc - \Fll(l

+3.20%+3J6%

*Market-adjusted return subcracts the market movement over thesrx weela post-decision.

EXHIBIT 2COSTS TO CAPTIJRE RESEARCH ADVANTAGEBuys Sel]s Round-Trip(Buys - Sell$

Total Execution Cost -2.44%Absoiute ReturnNet of Costs +2.97%Market-Adjusred ReturnNet of Costs +0.84%-4.74%-2.95%4.86%

-3.28%-0.08%-0.01%

and actual rerurns over a six-week period. Six weeks issuficient to measure the short-term value of a firmtdecisions while accuraceJy assessing implementationcost (see Wagner and Edwards [1998]). In this study wemeasure decision value and costs from desired date ofdecision through the subsequent trades. -W'e then com-pare end-of-period price ro the price at the time ofdecision and to the actuai trade price, revealing bothpotentiaL and captured return.Exhibit 1 shows the potential buy and sellreturns (excluding any trading costs) for over forryinvestrnent manager clients for the second and thirdquarters of 1997 . Exhibit 2 shows the captured rerurnsfor the same buys and sells, comparing decision price tonet trade price. it shows that the cost of getting ideasinto portfolios offsets the research advantage. 'We seechis pectern repeetedly each quercer.These runaway execunon cos$ were largelyignored until the 1990s. All the star appeal in activemanagement concerns stock selection (picllng win-ners) and not green eyeshade cost accountrng. Yet, withindex funds grabbing a24o/o market share of 1997 pen-sion equiry assets, managers are becoming aware thatefici.ent cost control is as importrnt co net rerurn asSPR]NC I999 fHEJOURNAL OF PORTFOLTO M NACEMENT 19


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EXT{IBIT 4ACTUAI INTPLEMENTATION COSTSCost x Completion Rate = Net Cost

Execurion CosuPostponement Costs

Tocal Implementation Cost

CommissionBroker ImpactTiming DelayOpportuniry

-R hn- 'r-?-l hn-l t1 hn-383 bp

-R hn" "r94%6% -106 bp

-160 bp

than 80% of the shortfall. These costs are not due totrading badly; they are dLre to not trdding when it wouldbe advantageous - but more cosdy - to do so.The raw opporturury cost is the forgone returnfor the unexecuted shares. The missed rrades wouldhave returned 383 bp over six weeks had they beentraded at the decision prices, whjle the shares acruallytraded returned only 147 bp. Emphasizing low-costbrokerage worsens performance lvhen "safe" low-costdecisions are emphasized, while more expensive butmore valuable decisions are deferred or abandoned.Expanding on Berruteint first saying, tailing co"venture" cheam the porrfolio of gains, but aiso addshidden costs, thus hurting performance in wvo ways.THE PERSISTENCE OF PRICE MOVEMENT

This brings us to Bernstein's second concept:diversification. Managers make many investment deci-si.ons, yet neither manager nor trader knows a priorilvhich ideas are winners, even thoLlgh the overall selec-cion process demonsrrabiy adds value. Trading onlywhen the market provides low-cost execucions leads toEXHIBIT 5RELATIONSHIP AMONGIMPLEMENTATION COST COMPONENTS

adverse selection: an executed ser oftrades chat lagsreturns of the desired trades. To wrn the active maagement game, then, the trader's 6rst goal nust beplace all the manager's bets - to trade all the orders'W'hile decisions add value on auerdge, not evdecision will be a winner. According to our date, o55% of decisioru add vah-re. Professional money magers put great falth in their research processes, yet rbenefit only when che overall market comes to agrmenc with rheir logic.To overconre the ftustration of markets thai"out of sync," managers may implement positive pfeedback timrng strategi.es to emphasize those stock pifor which the market is concurring. Traders, in cEast, are drawn to cheap liquidiry which leads to psuit of negariue pricefeedback sitr-rations. This places magers and traders ac cross-purposes.The result is that many of the manager's bdecisions either become underweighted or are neexecuted. Meanwhile the weakesr ideas - whi.chthe easiest to trade - end up firlly executed, therdominating returns and leading to underperformancPRICE PERSISTENCE

We show that rimely manager decisions embsufficient pri.ce persistence over a slx-week lvindowvalidate a posirive feedback approach. Then rve shthat market confirmacion srgnals can be used to hmanager and crader identify l,vhich decisronsemphasize or co avoid. Finally, rve sho.,v that tradertoo often fail to use chis confirming intbrmatifocusing instead on di.scovering cheap liquidiryreducing trading costs. The result is an operatiodrrg on Perforrnence'posidve feedback sraregies rely on price pe

2 0 c^pTuzuNc TllE R-ESEARCH .\DVANTAGT SPRING


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tence. Although we cannot argue in favor of technicalmodels for stock-picking, we find that rinring overlaysadd value to fundamental stock selection. 'While largetrades impact stock pricing for a short period,inevitably prices reflect the composite of ail investors'judgments. Thus persistence reflects the flow of infor-mation as i.nvestors seek a valuation consensus.Over time, fundamentals have to win. But in theslx-week horizon used to analyze executions, trendsdominate. Exhibit 6 summarizes a more detailed srudyof the same 1997 data.* We group trades according tostrong, neutral, and weak price momenrum categoriesbased on rwo-day price returns prior to decision. Buysrising or sells falling more than 4o/o ere iabeled strong,while buys falii.ng or sells rising more than 4Yo arelabeled weak. We then calculate market-adjusted thirry-day returns for each momentum group.The numbers in the firsr coiumn in Exhibir 6show refurns and the percent of observarions &om thetotal set, based on these inirial momentum groupings.The strongest orders result in the best eventual returns,while the weakest orders continue to lag.Next, we subdivide each momentum groupbased on price changes for the rwo days Jollowing theinitial order. Buys into srrengrh rhat conrinued to rise arIeast 2Yo and sells inco weakness rhat dropped atleast2Yoare viewed zs confrmed. Reversions of greater than 2o/oare flagged ts reuersals. Al1 orher orders (che majoriry ofthe observations) are labeled as flat. We rhen calcularethrrry-day marker-adjusted rerurns on each subgroup.

Managers Seek Positive FeedbackThis study shows that the best performance,exclusive of inr.plementation cost, comes 6-om selecdngstocks for which the market currently appreciates thenews. The odds of selecting winners increase when thefavorable tend is confirmed in the wvo days following

the trade. Conversely, falling stocks rhat conrinue ro fashow the weakest returns; these are the losing bets. (Buthey will be cheap ro rrade.)As a practical rool, market confirmacion capoint managers and traders in the direction of the besdeci.sions. Indeed, we find that momentum and growthmanagers often use market confirmation to add texisting orders. Thus, the trade desk plays a criticafeedback roie in helping rhe managers decide whichorders to pursue aggressively.The interesting parrs of Exhibit 6 are on rhexlremes: the relative handful of trades that showstrong or weak price signals. Managers wili want tpursue stocks showing price strength and deemphasizestocks with weak prices. As we will show, rradinproblems arise in deairng wirh these extremes, noc indealing with the bulk of the orders rhat show lesvolatile price movement.'W'hy do these trends persisr? Managers often sathat good news begets more good news. 'We believernore likely explanation is rhat trading inrerest begetmore trading interest. This is not an argurnent fomomencum management. Rather, it is an encouragement for better manager-trader coordination. Tiadercan provide addicional information thar helps steer managers away from the least successfi:l stock selecrions.

Traders Seek Negative Price FeedbackHow do rising buys and falling sells afi-ect thtrading process? The evidence shows a conflict of interest. Whiie manasers are oriented toward ma.xim:zingreturns, trading displays higher sensitiviry ro cosrsWhere managers seek positire price feedback, rrading displays a negatiue priceJeedback parrern.Exhibit 7 shows the development of rerurns alarge institutionai orders are worked for several daysThe bars represent raw returns (rhe difference berween

EXHIBIT 6THIRTY-DAY RETIIRNS FOR LARGE.CAP BUYS30-Day Market-Adjusted Return (% obsewati.ons)

Inidal N{omentum SrrhcenrrentRetum (% obs.) ConfirmedPrice Tr'end Condicion 2 Davs After OrderFlat RevenedBuying rnro SrrengthNeutral MomentumDUylng lnto WeaknessSPRING 1999

e.6% (7%)2.1.% (8670)-8.0% (7%)17.1% (37%)ss% (15%)-rs.8% (31%)

5.6%2.7%-4.8%

(41%)(67%)(47%)

4.s% (22%)-3.3% (17%)-3.8% (22%)THEJOURNA]- OF PORIFOL/O MANAGEMENT 2


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EX}IIBIT 7DAY-TO-DAY TRADINGEMPHASIZES CHEAP STOCKS15017q

^ 1008ruicu;25-o tr10t5f! Tmded Retum I Unerecuted Share Retum

-% freded

the price when the desk recerved rhe order and theclosing price) for borh rraded shares (wtr-ice) and as-yecunexectrted shares (black) as days move from the releasedace (0) to fifteen days posr-decision. The modesr rrad-eri return implies rhat rhe bulk of trading acriviry occursin response to neutral or weak price movement, lvhilethe much stronger tmexenfted share returns reflect reluc-tance to trade if the pocenrial cost is high.This pactern is represenrative of most desks:Orders with strong price moves are often deferred inhopes of price reversion, .,vhile rhe flat (cheap) tradesare quickly execnred.Exhibir I shows rhe impact of rhis behavior oncosts. As rhe stronger residual shares are execured, chemareinal cost per sh:ire (black) more rhan quintupJ.es.Irorucally, these trades appear cheap in terms of inrra-day market impacr by the dme they are execured, buicperformance has been eroded by the hidden delay cosrs.A mrnager lve knolv once described his trader assomeone who was "congerutally unable to step up."EX}IIBIT 8GROWING INCREMENTAI COSTSINCREASE TOTAI COSTS

Erdo.dcd Itudrcq-rlrdd

This telling statement sholvs horv dift-erenrly rnanageand traders perceive risk. To a manager, rhe risk instock is the possibiliry of nor achieving expecred prigrowth based on fundamenrai research. The trade deholvever, gauges risk reladve to recent tradino r:rnqecmuch shorter horizon.When i.nformarion flow is low, prj.ces often mor,vithin a narrolv band, and lead to lorv-cosr tradiopportunities. Danger arises when prices move oucsnormal ranges. When rrend takes over, trading needsbecorne more aggressive. The crader lvho delays compromises the most valuable decisiors. Unfortunaterraders' all-coo-human terrdencies are abetted by sposor pressure to dance to the cos[-minimization cune.

IMPACT OF MANAGEMENT STYLEON TRA.DING COSTSExhibic 9 shorvs that grorvth managers issmany more strength-oriented orders than value maagers, 16% versus I0% for lrrge-cap and 23% vers

1.4Yo for small-cap. Nore that value management oftdoesn't mean contrary - even value managers ftquently seek price confirmarion.Value traders often believe they have much higer percentages oFweak orders, justifiTing a tendencytrade with minimal impact. Exhibir 9 relis a diff'erestory for weakness-oriented orders. Value manage

issue only a siighciy higher proporrion of conrrrorders than gror,vth managers, 8% versus 7% for largcap mxnagers and 10% each for small-cap manageBoth groups are equally rempred ro rake advantageprice breaks co iruciace accion.

EX}IIBIT 9\VHAT PERCENT OF ORDERSREFLECT MONIENTUI{?

LCVaILCGro

SCVaIi SCGro

?, CAPTURINC TH RISEARCH ADV,\NTAGE SPRING 1


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Thus, we can add a third saying to Peter REFERENCESBernstei.n\. Itt not, "A penny saved is a Penny earned,"because overzealous cost conrrol snufii out ,irty oppor- Arnott, Robert' "Quantitative lvlanagement: Its Roll .intunities. A better one is "'Tis many a rUp '**J."it*a Coming Decade.'' Financial Analysts Jouma!' May-June 1994'|ip." Good execurion is essential to investment success. Bemstein, peter. Speech de|ivered at rhe 6fth Plexus Gro

Conference, LPnl 2' 1997 'ENDNOTES ,,How Trading Can Distort Invesrment Selecrion." PleGrouo. 1993."'We eliminate all small "cash" decisiors (less than 20,000shares for large-cap [> 2.5 $bil] and less than 10,000 shares for Wagner, 'Wayne H., end Mark Edwards. "lmplementsmall-cap [

capturing the research advantage

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