Investment managers and their clients have been reviewing the costs of executing transactions for more than twenty years. Initial efforts began in the United States in relation to U.S. equity securities. Analysis was fairly basic to begin with but at least clients were able to get a sense of their absolute and relative effectiveness in trade execution. Technology restrictions meant that reports were presented in hard copy, usually no more often than once a quarter. Execution was compared with a single benchmark only and there was no ability to “drill-down” into the data. Different service providers competed on the basis of the appropriateness of their benchmark. This rather than the quality or usefulness of analysis determined which services prospered. Most U.S. academic literature on the subject focused on how costs should be measured rather than how analysis could be used to reduce them.

The passage of time and the growing implementation of technology throughout the industry, led to a broadening and deepening of the analytical approaches. However, most of the technology initially deployed by service providers could not be upgraded without significant expense. Many of the founders of transaction cost analysis were therefore absorbed into larger organizations; custodian banks or investment banks looking to upgrade their performance measurement offerings. As a result the evolution of the business has seen a sharp decline in the number of genuinely independent service providers. In an industry as fraught with conflicts of interest as securities trading and execution measurement, such a loss of independence is very detrimental for clients.

More effective use of technology has seen a number of benefits for clients. Almost all service providers now recognise that using only a single benchmark of performance is likely to result in misleading analysis and no real improvement in performance. Most clients now receive analysis based on a number of different measures of market impact, cost of delay, implementation shortfall and opportunity cost. Secondly technology facilitates more timely and more frequent presentation of results. Most clients receive analysis monthly or in some cases weekly. Daily reporting however has not seen a large take up as most buy-side traders do not have time to study the information that frequently, and any trends would be hard to discern with daily shifts in performance.

Finally service providers are now following the lead of other industries in making information available via the internet. Progress here is not as widespread as might have been expected but the leading providers have deployed intuitive easy to use systems web applications that encourage thoughtful and sophisticated analysis of the transaction cost data.

Philosophically therefore there is no longer a “battle between benchmarks” for superiority. Rather the industry now recognises that clients will want to view performance from many different perspectives using many different benchmarks. Clients also want to analyse data in ways that reflect unique characteristics of their own organisation, processes and procedures. Custom reporting that highlights ways in which trading results can be improved has taken the place of standard reporting that shows whether historic results were good, bad or in most cases indifferent.

There is however a second trend reflecting the growing involvement of broker/dealers. That is the potential to confuse transaction cost analysis with execution monitoring. The latter used to be provided by experienced sales/traders at broker/dealers who would keep clients updated with the progress of their orders and at times recommend changes to the execution strategy in light of changing market conditions. With continuous pressure on broker margins, there is a desire to replace people with machines that show the progress of orders. This is a comparable outcome to the growth of direct market access and algorithmic trading, each of which is designed to lower broker costs by eliminating personnel.

Clients should not however confuse execution monitoring with post-trade analysis. The two areas have different objectives, use different technology and serve a different purpose. In all likelihood, unless sales traders suddenly reappear, investment managers will need help in monitoring execution, probably in the form of systems provided by brokers. This is not transaction cost analysis however. That will remain the preserve of more dispassionate reviewers of performance looking to advise their clients how to do better generally, rather than focusing on the immediate challenges of single transactions, important as these may be.

History supports the view that effective transaction cost analysis should, can and does lead to better quality of execution and enhanced investment performance. The gains involved may not appear large at first site. However in an era of lower investment returns generally and a focus on the very small amount of real “added alpha” offered by most investment managers, such gains may be critically important to long term business success for institutional investment clients and the pension funds and individuals who appoint them.

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