Best Execution: 201

In our last write up, “How to conduct Your Best Execution Review: Part 1” (5 min read), we provided an introduction to best execution and the fundamentals for performing a best-ex analysis. (As a reminder, from the SEC website “Brokers are legally required to seek the best execution reasonably available for their customers’ orders.”)

We talked about arrival price and VWAP and promised if you read to the end, you would be an expert in best execution or transaction cost analysis (TCA). That still holds but there is even more to the analysis. Consider this to be the advanced course in best execution analysis.

Percent of ADV

Average Daily Volume (ADV), usually calculated by averaging the last 20 days of a certain instruments trading volume, is an important metric when trading in the public marketplace. It is a measure of expected trading activity and gives you a good indication of a security’s liquidity. This in turn provides an estimate of how much an investor can transact in a trading day.

As an example, if a stock has a 20-day ADV of 1mm shares and an investor is looking to invest 100k shares, this order would be 10% of the stock’s 20-day ADV. The investor could expect to be approximately 10% of a day’s volume and will most likely not have a problem completing the order in one trading day. (It is important to note that if an order is 10% of a stock’s ADV, this does NOT guarantee the order will be 10% of that day’s trading volume. The 20-day ADV is simply a forecast for the next day’s volume and by no means an exact measure).

Knowing the percent of ADV (or AIDV) of your overall order flow, or the size of your orders, across various dimensions (broker, market capitalization, etc.) is vital when comparing execution performances.

If the order flow to one of your brokers had an average of 35% ADV while a different broker had an average of only 10% ADV, this is a big difference and the first broker had much more difficult order flow than the second.

Participation Rate

Participation rate or how much of the day’s volume an order was (executed shares/volume of security during execution), is another important factor when analyzing execution performance. Often confused with Percent of ADV (which is calculated before execution begins), participation rate is calculated after the order is completed and is a measure of how much the broker participated in the day’s volume.

Interpreting participation rate is a tricky one. Too low of a participation rate and the broker was not aggressive enough and may cause a high opportunity cost. Too high of a participation rate may cause excess impact and give you an inflated average price which eats into your returns. It is important to calculate participation rate using the trading volume of the security during the time of execution and not necessarily the entire day’s volume of the security.

Duration

Duration is simply the difference between an order’s start time and end time. At the aggregate level, duration viewed across various dimensions is yet another good indicator of how well a broker executed your order. A very short duration indicates a broker may have simply sent the orders to market, caused excess impact and not had your best interests in mind. Too long of a duration may cost you in opportunity and indicate the broker is not being aggressive enough.

When measuring duration, be sure to use the start time of when the broker received the order, NOT the time of the first fill. Brokers should be held accountable from the time they receive the order.

Reversal

Reversal is another excellent post trade metric to monitor execution quality. It is measured as the price movement from the end time to a certain time period after the execution, e.g., 5 minutes, 30 minutes, close, next day close. This metric is an excellent indication of excess impact and may be the source of buyer’s remorse after watching the price drift back to more favorable levels.

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