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COMMENTARY 57 DECEMBER 1998

RET'ISTTING DIRECTED BROI(ERAGE: STTLL NCD FREE LUNGH
A 7996 Plexus study of one clrent's drrected and non-dtrected trades concluded that whrle drrected
trades had lower tmpact and commisslon cosrs, trmrng and opporlunity costs outwelghed the sav-
ings. More importanLly, drrected lradlng discourages lradrng rn raptdly movrng sltuattons. leadtng to
significant underperformance relatlve to non-dtrected trades. Thls follow-up study of more clients and
a longer time frame, comes to slmrlar conclusrons that [7J dlrected trades show no cost advantage
when adjusted for expected costs, ancl [2J rndrrectly emphaslzrng lower cost trades leads to lower
returns than reallzed throuqh non-dlrected trades.

How many sponsors would agree that NYSE Rule 122 specifically prohibits
higher commissions can lead to a member firm from trading a stock with

Plexus now has r"-rp to nine quarters of

many, we suspect.
"...CgptUring 3( Of COtn-
Sponsors who cap-
mission
ture commissions cost the direct- iob is to control
forfundadministra- ing sponsors 10.3(
'information
tion implicitly be- perform&nce..."
lieve that a higher
commission buys nothing of value.
Consequently. rnanagers continue to
feel pressure to direct commissions
to designated brokers for sponsor use.
The burden ofproof that commissions
can be a tool, not just a cost, has
fallen on the manager. Managers in-
tuit that direction alfects investment
perfomance, but seldom possess suf-
ficient information to demonstrate
that they are using commissions ef-
fectively.
Measuring the true cost of direction
requires looking beyond the obvious
costs of commissions and direct im-
pact. It needs to include timing costs
incurred while a directing broker
seeks or awaits liquidity, as well as
foregone returns when liquidity fails
to develop. These costs capture the
effects of disruptions to a manager's
normal execution strategies. While
proponents of direction argue that di-
rection should not disrupt a manager's
process, we show that differences re-
sulting from the sequencing of trades
can be significant.
broker at a time.
Since the trader's
of ,
flow
to brokers in a cludes both large-cap and small-cap
way that secures
best execution for all accounts, seqllenc-
ing of directed trades naturally results.
When prices move rapidly, timing
becomes a priority. Accounts that di-
rect trades to specific firms lose timing
advantage whrle recapturing cornrnis-
sions. How are we to assure this tradeoff
is in the client's best interest?
The 1996 Plexus study of a growth
manager's directed trading showed
that:
o Directed trades cost more than
non-directed trades; 1 I 2 bp as con-
trasted to 83 bp.
o The ratio ofcosts to expected costs
were more unfavorable for directed
trades: 560 o ove r expectation com-
pared to 40o over expectation.
o Serious problems developed in ex-
perienced net returns, -3.l9oA for
directed trades vs. +0.470% for non-
directed. As a result, directed ac-
counts realized lower returns for
traded shares.
directed trading data for eight clients.
This sample provides both a deeper
pool for comparison and a good cross-
section over time. The sample in-
as well as value and growth strate-
gies. ln 1Q98, the sample included
$48 bil. of decisions of which 22%
represented directed decisions.
Because the analysis covered a
broader range of investment styles, the
effects of delays were reduced. Tim-
ing costs for directed trades fell, com-
paring more favorably to the non-di-
rected trades. However, the bench-
mark costs for directed trades also fell.
As a result, directed trades lagged
their benchmark by 400%, compared
to 8% for non-directed trades.
An interesting finding was that im-
pact and commissions converged for
the two groups of trades. Directed
impact * commission costs rose from
25 to 2l bp, while non-directed costs
fell from 39 to 33 bp. This is consis-
tent with the steady drop in average
commission rates due to increased use
of Proprietary Trading Systems such
as lnstinet and ITG/Posit. The ques-
tion appears to be no longer the level
of commissions; rather how the com-
missions are used.
 Returns: tlre Bottorn Llne fon
In the first study, we concluded that the
most damaging aspect of directing bro-
kerage was the 'adverse selection' in-
cured when directed brokers fail to ac-
cess liquidity in last moving situations.
Because our first study covered a growth/
momentum-oriented manager, missed
trades led to a large difference in retums"
Adding more styles dampens the differ-
ential. but the perfonnace gap persists.
The significant difference for plan
sponsors again occurred in the realized
rates of return frorn trading. Market-
adjusted 30-day retllrns for directed
trades averaged bp versus +23 bp
for non-directed-10
trades.
On a cumulative basis, non-directed
trades retumed +212 bp versus a loss
of 87 bp for directed trades. Consis-
tent with theory, directed trades out-
performed in only one period -- a
quafter when average decision returns
were negatlve.
Momentum-style managers and small
cap managers appear to need all the
broker flexibility and cooperation they
can muster. Value managers, however,
find time delay can be an ally, and di-
recting may result in serendipitious de-
lays. The exceptions are worth know-
ing to a sponsor who wants to effec-
tively direct commissions.
The News!
Take a look at our new Website at
www.plexusgroup.com. Find out
more about Plexus. study past
commentaries, and soon access
Plexus Group services online.
The "Plexus Group Sixth Con-
ference Summary" is now arrail-
ablelWrite to us for a free copy,
0r e-mail your request to
info@plex usgroup.com.
Upcoming Speeches

Gonclusions ary 25-26. New york:

iunu
"New Technologies
The table below summarizes the re- The lesson is that effective direction of
tWayne lhagner)
sults. The benefits of recaptured com- trading requires careful planning. Plexus
"Measuring Best Execution"
missions, assumed to be 3l per share, Group recommends: (Steve Glass)
are added to gains which arise because
smaller directed trades have lower com-
1' Direct only a modest portion of
mission and impact costs. oft'setting commissions(10-30%)basedonboth CBOE, Risk Management
and capitalization' For
these gains is the finding that directed manager style January 27 -30, Scottsdale:
trades are more costly compared to their example' a large-cap value manager "Managing Transaction Costs"
can tolerate more directed trades than
benchmark (of what they should cost). (lVayne Wagner)
Finally, the performance of directed a small-cap value or large-cap growth
trades suffers when they are delayed or manager'
too 2. Choose directed brokers in consulta-
abandoned because prices moved
quickly. The performance penalty tion with the manaser.
Reprint any portion of this
amounts to almost 15d per share.
3. Use steo-outs as an alternative material with credit given to:
Adding all the components together, the
study shows that capturing 3p of com- 4. Consider whether the seruices pur-
mission cost tlle directing sponsors chased are essential to manager
plexuggroue
10.31 per share of performance relative performance.
to non-directing accounts.
5. Install a monitoring program to evalu- 11150 W. Olympic Blvd., #900
ate executions and perfotmance. Los Angeles. CA 90064
PH: 310.3 12.55A5
len-Oiree+cC ,
FAX: 310.312.5506
TRADING PERFORMANCE
i+aCe+ . nHl;. Also available at
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