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December 1, 2004

Best Execution for Hedge Funds

By Ben Mattlin

Every trader wants best execution. But for each hedge fund, it can often mean something radically different. "For hedge funds, minimal transaction cost doesn't necessarily mean optimal transaction cost," according to Robert Shapiro, former head trader at the $10 billion Iridian Asset Management, which includes $1 billion in hedge fund assets. At the same time as funds are watching best execution, they also need access to resources, such as sellside research, he says. That helps generate the all-important alpha. "Tack on an incremental commission charge," Shapiro advises hedge funds, to "pay for the alpha input drivers."

Unsurprisingly, many pros stress various reasons why best execution - at hedge funds and long-only funds - isn't simply about best price. "Suppose there are three people offering the same low price," says one industry professional. "You need to know which one has the most liquidity." Finding hidden pools of liquidity involves "a process of watching the tape, picking up telltale signs, and probing with what's called an immediate or cancel order," he explains.

Finding liquidity is not like it used to be. When the SEC introduced the famous order handling rules on Nasdaq, the initiative spurred the growth in electronic trading. ECNs and ATSs promoted more anonymity and narrower spreads. This would have long-term implications for hedge fund trading. Then, in 2001, decimalization decreased the displayed size on the NYSE and Nasdaq, and expanded the number of per-share price points to 100. All of this worked once again to accelerate the rise of electronic trading. And it facilitated the finicky demands of hedge fund traders. Electronic trading, for instance, can handle basket trading and larger orders efficiently. Typically, they break these large orders into small pieces for quick, anonymous executions. Now Wall Street brokers are increasingly embracing electronic trading, cutting costs, fighting hard not to loose buyside order flow to electronic competitors.