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November 8, 2005

New Analytics on the Way: But integration will be the key

By Richard Johnson

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  • New Analytics on the Way: But integration will be the key

To manage orders effectively in an increasing electronic market, traders need real-time cost and risk analysis tools integrated directly into the trading process. When looking at the US equity market over the last several years, it is interesting to note that the evolution of trade analysis, has been moving backwards. First came post-trade transaction cost analysis, and with it the volume weighted average price (VWAP) benchmark, as an easily understandable performance metric.

Then came the first generation of algorithms, which aimed to achieve the VWAP by feeding orders into the market following a typical volume schedule. Now the industry is at the point where buyside traders have access to comprehensive trade analysis services, a battery of broker algorithms integrated into the order management system, and are looking for pre-trade analysis tools to help them select the right algorithm to achieve their goals.

To manage orders effectively in an increasing electronic market, traders need real-time cost and risk analysis tools integrated directly into the trading process. When looking at the US equity market over the last several years, it is interesting to note that the evolution of trade analysis, has been moving backwards. First came post-trade transaction cost analysis, and with it the volume weighted average price (VWAP) benchmark, as an easily understandable performance metric.

Then came the first generation of algorithms, which aimed to achieve the VWAP by feeding orders into the market following a typical volume schedule. Now the industry is at the point where buyside traders have access to comprehensive trade analysis services, a battery of broker algorithms integrated into the order management system, and are looking for pre-trade analysis tools to help them select the right algorithm to achieve their goals.

Looking at this progression of transaction cost analysis, are there any predictable trends for the future? First, cost analysis will move further upstream as portfolio managers seek to incorporate pre-trade market impact analysis into the portfolio construction process. This is already happening, to a certain extent, at many buyside shops as traders and portfolio managers work together in teams to determine the most appropriate execution strategy given a trade's urgency and liquidity characteristics.

Portfolio managers will become more familiar with the pre-trade tools offered by brokers, and input market impact estimates into their stock selection screens or, for the quants, directly into the optimization process.

Secondly, with cost analysis firmly embedded into the investment process, traders and portfolio managers will demand more robust, dynamically updating transaction cost analytics. A huge drawback of the current three-step process is that it completely ignores all trade and market data until the post-trade phase, and thus makes it impossible to react to changing market conditions in order to improve performance of the trade. Ideally, market impact estimates should be continually updated based on real-time market data, and integrated directly into algorithms accessed through a system that allows real-time monitoring of progress and performance.

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