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March 9, 2009

A New Way to Judge the Buyside

MSIM overhauls trading performance metrics

By Nina Mehta

Also in this article

In the quantitative world of finance, evaluating the performance of traders has long been an important but elusive task. Now, as the buyside does more self-directed trading, it's becoming even more important to assess how well traders do their job and how much money this puts in the pockets of fund owners.

Clear answers aren't easy to come by. But Morgan Stanley Investment Management is currently implementing a framework it believes will quantify the value a trader delivers to the firm's investment process. MSIM, which plans to compensate traders based, in part, on the numbers that emerge from its calculations, hopes other firms will embrace a similar methodology to bring more rigor to the trading discipline.

"The goal is to align the performance evaluation of traders with the way investment managers are evaluated, and the behavior of traders with the objective of the firm," said Robert Shapiro, an executive focused on trading and execution analysis at MSIM. The objective, he said, is to "preserve, protect and grow client returns."

That's a laudable ambition. But the impetus for all the mental effort is simpler. "Traders believe in their heart of hearts that they add value," Shapiro said. "We're hoping to quantify the extent to which traders contribute to the objectives of the investment process."

Buyside firms have wrestled with these issues for a long time. In this, MSIM has company. Fidelity Investments, Franklin Templeton Investments, Wellington Management and AllianceBernstein Investments have focused intensely on trading metrics. Franklin Templeton, for instance, analyzes two-dozen benchmarks that help it evaluate different aspects of the trading function for the large orders it executes, according to Bill Stephenson, head of global trading strategy at the $416 billion investment firm.

Transaction cost analysis, of course, has existed since the 1980s. Its focus has been on using benchmarks and analytics to try to ensure the best trading outcomes. But figuring out exactly how much better one trader did than another is complicated by a range of factors, including the orders the trader is given to trade, the time horizon, the stock's liquidity and the market volatility.

MSIM's effort to quantify the value traders provide got its marching orders from Ray Tierney, global head of equity trading at the firm. When the 26-year sellside veteran moved to the buyside in 2006, he decided more metrics were needed to excavate the value traders bring to the investment process. "In our business, we're paid for the executions we get every day, so we need to know exactly what we're getting," he said. MSIM has just over $200 billion in equity assets.

The PM Perspective

MSIM set itself a straightforward task: to lay out the metrics needed to evaluate traders the way portfolio managers are evaluated. PMs are judged on their absolute returns, their returns relative to a passive benchmark such as the Standard & Poor's 500 Index, and their returns relative to their peer universe, MSIM's Shapiro said. So traders should be assessed, the firm decided, on absolute performance, relative performance and their ranking in their peer universe. Shapiro is a former head trader at Iridian Asset Management who was schooled in trade cost analysis during a stint at Abel/Noser Corp.