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December 1, 2004

Cost Cutting on the Buyside

By Stephen Alepa

Buyside traders have never been more important and empowered. Now they are prime players in the debate over market structure. For example, the pending reforms in soft-dollars and directed brokerage practices give traders an amazing opportunity to press their case. These issues - and how they are resolved - will mean traders have a chance to improve investment performance and prove themselves as a

profit center.

Recently, this critical role was brought to light in a front-page Wall Street Journal story about Fidelity Investments. This is an expensive place to move a stock. At Fidelity, a giant investment company, trading practices typically add between 20-30 basis points - and as much as 37 basis points - to annual fund performance.

So, what can pricey desks do to recoup some of these high costs that as the Journal story reported - Fidelity is recovering? One way is to follow its example and spend $120 million on new trade tracking technology. Doesn't fit your budget? Then create a best execution business model (BEX) that takes into account your asset management enterprise; includes pre-, intra-, and post-trade performance measurement; and has a flexible trading system that will adapt to change.

Sure, much has been written on the technology and measuresment components of this BEX framework. However, little has been said on its organization. An enterprise-wide BEX framework is open to traders, portfolio managers, and even sales, marketing and client servicing personnel. A BEX framework confined to trading, while helpful, is also shortsighted. That's because in asset management the "process is the product." By looking across traditional corporate boundaries, synergies can be uncovered.

A portfolio manager is typically rewarded on performance. If one believes that a firm's trading practices can improve performance, then weaving estimated trading costs, for example, into the alpha capture process makes perfect sense.

I recognize that this may challenge the historical purity and sanctity of the portfolio decision process. But, heck, a basis point is a basis point. It is surely a positive sign when the chief investment officer places material value on the best execution process.

Even in those cases where the buyside head trader is claiming success because BEX has become a CIO issue, I postulate that the scope of best execution goes even beyond that in a typical organization. A common institutional RFP today, for instance, has numerous questions on execution practices. The concept of best execution is pushed as a key decision criteria by consultants who drive the manager evaluation and selection processes. Once the business is won, the best execution reporting requirements become more and more demanding. A recurring complaint from trading desks is the amount of time they spend manually mining data to satisfy these sales and servicing requirements. Unfortunately, this takes them away from the business of trading. Therefore, collaboration internally among these various parties to make sure the requirements are factored into the BEX model will be productive.

The trading desk itself will continue to see the most dramatic transformation when it comes to BEX. For this reason, head traders need to develop their business management skills. At the same time, compensation should include an incentive that recognizes best execution measurements. In fact, a system that encourages a speedy and objective evaluation and the use of new trading tools is needed. The notion that technology is something to embrace - as opposed to something to be feared - needs to become universal across the desk.

Finally, there is no arguing that there has been a tremendous shift in the buyside balance of power in the trading process. Those that prosper will be the desks and organizations that recognize this dynamic environment. It follows that constant change is a reality. Firms must tailor their organizations, business processes, and technology investments with this in mind.

Stephen Alepa, CFA, is executive vice president, Macgregor.