Where, asked T S Eliot, is the knowledge we have lost in information? Investment managers have no shortage of information about the trading and settlement of their securities. But do they have enough knowledge?
Managers know how to tap into broker research and transaction cost analysis from a large pool of providers. However, they may not know the value of the information they are getting from these sources.
More important, they may not know whether the information they are getting helps improve investment performance or contain costs. Trading costs are the largest single expense plan sponsors are likely to encounter.
Global custodians are now looking for better ways to measure and analyse global equity trading costs. State Street has acquired a majority stake in Elkins/McSherry, one of the US’ leading providers of transaction cost analysis (TCA), to bring in-house the methodology needed to track the administrative and execution costs of clients’ funds. Commissions, fees and market impact are compared to a universe of similar costs so that clients can assess their own fund and portfolio expenses.
JP Morgan Investor Services (JPMIS) has perhaps gone furthest in trying to produce an end-to-end review of costs. Over the past three years it has developed a complete set of evaluation and benchmarking tools to enable managers to check the value of the research they are getting. The demand for a toolkit came from the clients themselves, says John Phinney, information products senior vice president at JPMIS: “A number of our clients asked us to help them understand how they could manage their resources better, particularly in the light of the fact that if the bubble burst they might be challenged to get the best out of their resource base.”
The starting point was to break down total cost measurement into three components. The first component is the analysis of broker research. “The number of third-party research providers has grown dramatically over the years and the value that these providers generate for the managers is difficult to quantify,” says Phinney.
“The basic questions managers were asking were ‘how good is the information we’re getting, what are the key factors that drive value for us as a firm, and are we ranking and assessing third party providers in an objective and transparent manner?’
“Clients wanted quantitatively driven benchmarks that would enable them to define their network of research suppliers, assess the value of the research provided, and examine the compensation to their suppliers through trade order flow.”
The second component is the implementation of investment strategy – in other words, trading. “Clients need to know how well trades are being executed by a manager and what they are costing them.”
The third component is the monitoring of settlement. “Here the questions were are we doing as well as we can with the resource, and what type of cost was the manager incurring to execute through a defined network of third-party brokers? Were failure experiences causing hidden costs to accumulate in their middle or back office?”
JP Morgan has taken a consortium approach to bolt these three components together. Analysis of broker research is handled by an alliance between JPMIS and Investars, a US supplier of performance measurement services for equity research. Investars uses a proprietary methodology to rank research firms according to the performance of hypothetical portfolios for every stock and sector.
Analysis of trading costs is the business of Plexus, one of the four main providers of TCA in the US , which JP Morgan acquired last year. In common with other TCA providers, Plexus uses computer files of a client’s trade data to compare against a segment of the entire trading universe and run algorithms against them. The results are then distilled into recommendations for improving investment returns through better trading practices.
JP Morgan also formed an alliance with Inalytics, a UK-based provider of TCA and best execution products. Here the aim is to provide distribution and servicing support for JP Morgan Plexus products across Europe. Phinney says JP Morgan was attracted to Inalytics not only because of its strong servicing capabilities but because of its interpretation and communication of TCA results: “We found there was a tremendous amount of consistency, not only in the way we viewed the TCA product but in what we are really here to do.”
Finally, to check out what is happening at the settlement level, JP Morgan uses its own web-based application TradeSTARR (Trade Settlement Tracking and Relative Ranking System). TradesSTARR uses aggregated statistical data to help investment managers analyse their particular trade settlement experience with broker dealers, benchmarked against a relevant universe. It can also be used to lower the operational risks and exception processing costs of failed trades.
Binding together the three components of total cost management with web-enabled application technology allows the manager to do three things, says Phinney. “The first is to assemble the data in a highly efficient manner necessary to perform the examination of the three activities – research, trading and settlement. The second is to establish a series of ‘custom’ views of values. What differentiates us from some other providers is that we don’t tell clients what is valuable. We allow them to tell us which factors they consider valuable, and then we use our unique universes to provide the actual calculations to give them back the answers to their questions.
“The third is to wrap it into a consultative model that allows an extension of the basic product into the collection analysis and reporting of data observations. This allows us to work with client decision support, decision implementation and decision monitoring.”
Whether clients get the full package of services depends on their needs, says Phinney. “ We have 1,500 clients around the world. They all have different levels of need.”
Clients use a ‘four-step model’ to decide how far they want to go, he says. “Step one is observation – what is going on within my network from a cost point of view and as regards benchmarking, and where do I sit relative to my peer group in the research, trading realm and settlement?
“Step two is the decision-making process – what are the choices and actions that I can take to correct or improve that condition?
“Step three is implementation analysis – you’ve observed the condition and you decide to do something about it. Did you make the right decision?
“Step four is whether you want to extend the same level of benchmarking and performance management. to all of your suppliers – whether they are research suppliers or broker dealers.”
The first European client for the product is UK-based Isis Asset Management, which recently awarded a mandate to JPMIS to manage $12bn of assets under custody. Under the mandate JPMIS will provide a range of added value services including total cost measurement.
“Essentially we’ve put together a package of services which we’ll be providing Isis which ranges from research to transaction cost measurement and then on to settlement efficiency, wrapped together in a single product ,” says Rick Di Mascio of Inalytics.
The demand for trading cost measurement will be driven by the search for alpha, or stock specific rather than market specific returns, says Phinney. “In this era of single-digit returns, you’ve got people jumping up and down for 20 basis points. The average observed improvement, post implementation, of the recommendations that we have helped clients execute is 60 basis points across multiple asset classes.
“The deliberate examination of the factors that drive performance – how your broker-dealers are executing your hold-over trades, your limit orders or your market orders – is vitally important to understanding what you can do to move the needle a bit in performance.”
The costs of moving the needle are comparatively low, he suggests: “Based on research we’ve done in the US we estimate that the total cost of the JPMIS application for the billion dollar manager would be roughly four basis points. When you look at the alpha capture opportunity of anywhere between 20 and 300 basis points, this is a fairly inconsequential cost.”
The demand for end-to-end measurement of costs is likely to increase in view of the increased interest of the Securities and Exchange Commission in the US, the new AIMR best practices and the trading recommendations of the Myners Commission in the UK. Specifically, the consultation exercise by the UK Financial Services Authority has put the spotlight on broker research, best execution and settlement.
Di Mascio concludes that the timing of the launch of end-to-end cost measurement could not have been better. “ We’re actually addressing all these very real concerns and needs within the industry here and now,” he says.

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