EL I M I N AT I N G UN N E C E S S A RY CO S T

RE D U C I N G TR A N S A C T I O N CO S T S A N D

RE C A P T U R I N G VA L U E F O R YO U R PO RT F O L I O

For more information please contact your

Instinet Group representative or visit us

online at www.instinetgroup.com.

1

INTRODUCTION

Transaction costs can be a significant part of the expenses incurred by an investment managerimplementing its investment strategies, and a drag on the performance of its assets. Every dollar spenton executing a strategy — both in brokerage commissions and hidden trading costs — is a dollar lost tothe plan’s participants; in fact, more than a dollar once foregone returns are considered. Plan sponsorshave traditionally left the problem of transaction costs to their investment managers — and with goodreason. Asset managers are "prudent experts" — a fiduciary with expertise in the field, bound to the bestinterests of the plan, and who can make informeddecisions about how to execute a strategy,including which brokers to use.

Investment managers are professionallymotivated to minimize trading costs in order tomaximize performance. Managers often apply thesame level of rigor to implementing a strategy asthey do to security research and portfolioconstruction. Moreover, given the increasingmedia and regulatory scrutiny of these issues, theresponsibilities of investment managers are onlygetting more difficult. Now, more than ever, theirsingular focus must be on serving the customer inthe most efficient, transparent, and unconflictedmanner possible.

In our over 30 years serving the investmentmanagement community, we have worked in partnership with our clients to find solutions that havebeen beneficial to both managers and sponsors. These solutions not only deliver the greatest value backto the investor, but do so in manner that provides the greatest amount of disclosure of transaction costs.

This transparency allows the plan sponsor to assure their stakeholders that their money is being usedefficiently, and that they are doing everything possible to avoid the loss of value due to unnecessary costs.Throughout these decades of partnership with our customers, we have learned one golden rule ofinvesting: you can always return greater value to the investor by lowering transaction costs. It’s not themost exciting or glamorous topic, but it is the most reliable way we can help improve returns. At Instinet,we’ve built our business by relentlessly chipping away at transaction costs in the most open andtransparent fashion possible.

TRANSACTION COSTS, VISIBLE AND INVISIBLE

Transaction costs are incurred every time securities are bought or sold. These costs are both explicit —for example, any commissions paid — and implicit. Implicit costs, usually the larger of the two,include, for example, the adverse effect that the trade itself may have on the price of a security, knownas market impact, or the opportunity cost of failing to execute a trade.

Transaction cost measurements capture both visible and invisible costs — that is, total trading costs.The best way to think about total transaction costs is as the difference between a paper portfolio and areal one. A paper portfolio is an imaginary portfolio in which the securities an investor wants to holdare all acquired instantly, without cost, at a given benchmark price, say the previous day’s close. Thevalue of this portfolio can be compared to the value of the real portfolio, once constructed, in which alltransaction costs have been reflected.

Investment managers must focus

on serving the customer in the

most efficient, transparent, and

unconflicted manner possible.

2

The difference between the two is commonly known as "implementation shortfall." Implementationshortfall represents the total shortfall in the value of a security (or portfolio) that results fromimplementing the trade—or failing to do so. This approach to measuring total transaction costs wasfirst described in 1988, and has since become the methodology of choice.1 (See Appendix: InsideImplementation Shortfall)

HOW IMPORTANT ARE TRADING COSTS?

Transaction costs can have a significant effect on returns. Implementation shortfall in U.S. equitymarkets has been estimated to range from 20 basis points to as much as 2% of the principal value oftransactions and orders.2 The wide range is partly due to differing assumptions about opportunitycosts.3 Taking the mid-point of the range, however, even an average 1% per year in lost performance,before inflation and taxes, compounded over the average life of a pension liability, representssubstantial foregone value. If we apply it to the $12 trillion U.S. equity market, we get approximately$120 billion lost to transaction costs every year.4

An example of implementation shortfall cited by one study was the performance of a portfolio of stocksrecommended by Value Line, an independent research firm. From 1979 to 1991, the Value Line portfoliohad an annualized paper return of 26.2%. The actual performance of the Value Line fund that investedin these stocks was 16.1%. The difference — more than 10 percentage points per year — representsimplementation shortfall.5

The chart from Plexus Group demonstrates implementation shortfall by comparing the "potentialreturn" (paper value) to the "realized return" (actual value).

(Manager conducts research and develops a sound investment strategy within an optimal environment.)

0

5%

10%

15%

20%

25%

30%

-10 -5 -2 SecurityPurchase

Date

1 2 3 5 10 15 20 30

Ret

urn

Days Prior

to Security Purchase Date

Days After

Security Purchase Date

Implementation Shortfall

(Total Transaction Costs)

Potential Return

Realized Return

Research Period

Potential Return

Realized Return

LOST POTENTIAL

IMPLEMENTATION SHORTFALL MEASURED OVER THIRTY DAYS.

Source: Plexus Group.

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The vertical axis shows the rate of return on the investment decision. The horizontal axis shows thedays prior to and after the security purchase date. The chart shows that even though a manager mayhave made a well-calculated, solid investment decision under optimal market conditions withinformation as much as 10 days prior to the date of the purchase of a security (-10), value can still belost due to implementation shortfall. The shaded portion of the chart, the section between the potentialreturn and the actual return, is the amount lost in the time from trade decision to trade completion asa result of transaction costs.

TRANSACTION COSTS AND EXECUTION — GOOD, BETTER, BEST

The legal definition of best execution is "the most favorable terms reasonably available under thecircumstances for a customer’s order."6 The definition is necessarily broad because it must apply to allinvestors and any market conditions. As a result, it is difficult to apply as a quantitative test. This doesnot mean, however, that best executioncannot be measured. It can, but themeasurement must take subjective issues intoconsideration also:

• The "most favorable terms" (e.g., price,speed, or certainty of execution) depend onthe investor’s goal. If an investor pays aninferior price to execute quickly against ashort-run profit opportunity—say, a takeoverbid—is this a failure of best execution?

• Opportunity costs count. If a brokerexecutes a trade at the best price available,and charges a low commission, but only fillshalf the order, has the duty of best executionbeen met?

Implementation shortfall is one measure ofexecution quality, though even it cannotcapture the context of the trading decision. Itdoes, however, measure total transactioncosts relative to the investor’s ideal outcome,thereby accounting for both the investor’s goals and opportunity costs. Under this approach, bestexecution is what removes the least in total transaction costs from the expected value of the investor’sstrategy. In other words, best execution is minimized implementation shortfall.

Of course, even with an effective measure, best execution is not an absolute standard. Executionquality is relative, a matter of comparing costs between brokers and investment managers to assesstheir average performance, while keeping in mind the specific investment strategies and risk tolerancesof the client, as well as the condition of the market at the time of execution. The goal is not toeliminate all transaction costs—an impossible task—but to find and utilize brokers that can minimizethese costs as much as possible.

The goal is not to

eliminate all

transaction costs,

but to minimize

these costs as much

as possible.

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ACHIEVING HIGH-QUALITY EXECUTIONS

Implementation shortfall measures best execution after the portfolio has been fully constructed.Investment managers, however, need a way to fulfill the legal duty of best execution throughout thetrading process. As a practical matter, how can this be accomplished?

The answer is to create the conditions under which it is most likely to occur. This shifts the emphasisfrom the outcome to the process. The investment manager meets the duty of best execution byfollowing procedures calculated to achieve it — it is, in fact, the "trading process … that seeks tomaximize the value of a client’s portfolio."7

A best execution trading process should incorporate a number of factors. Among the most critical arestandards that help the investment manager choose brokers that will support the process. As a result,many investment managers have begun utilizing best execution brokers. A best execution brokershould be able to:

• Protect client anonymity.

• Minimize total trading costs.

• Execute trades quickly.

• Help solve difficult trading problems.

• Provide efficient clearing and settlement.

• Search for and find liquidity to minimize market impact.8

How do best execution brokers accomplish this? Best execution brokers have generally designed theirbusiness model to have those characteristics, in an effort to increase execution quality, withoutancillary business interests that could result in higher trading expenses.

For example, best execution brokersusing an agency-only model—brokerswhose firms do not trade on aproprietary basis—eliminate thepotential for conflicts of interest.(When utilizing brokers that haveproprietary trading desks, there isalways the risk of the broker tradingahead of the client.) Anonymoustrading also eliminates the possibilityof information leakage, which canalso result in inferior prices. Typicallybest execution brokers systematicallyremove any other business interestsor practices that could negativelyaffect execution quality.

The investment

manager meets the

duty of best execution

by following

procedures calculated

to achieve it — it is,

in fact, the "trading

process … that seeks

to maximize the value

of a client’s portfolio."

RESPONSIBLE MANAGEMENT OF COSTS

Instinet Group has over 30 years of experience in working with some of the best investment managersin the financial services industry. With our expertise, we have identified three proven steps that assetmanagers use to insure that clients meet the fulfillment of their fiduciary duties by controllingtransaction costs and reducing unnecessary plan costs.

IDENTIFY TRANSACTION COSTS FOR YOUR CLIENTS

Explain to your client where costs are incurred along the trading cycle. Regularly measure executionquality, using a system that:

• Employs implementation shortfall methodology.

• Covers all orders placed, whether or not they are fully executed.

• Breaks costs down by broker and investment strategy — e.g., value, growth, etc.

• Separates transaction cost components — e.g., commissions, spreads, market impact, opportunitycosts.

• Reports back periodically to the plan sponsor.

Transaction cost disclosures should allow you and the client to compare brokers and investmentstrategies that have been successful in the past.

UTILIZE A TRANSPARENT BROKER SELECTION PROCESS

Ensure that your clients understand how brokers are selected and how commissions are allocated.Information provided could include:

• A general description of your firm’s commission voting procedures.

• A list of approved brokers and a rationale for each broker’s inclusion on the list.

• Procedures by which brokers are added to or removed from the list.

• Commissions allocated to each broker (in dollars and as a percentage of the total commission pool).

• The reasons for each allocation.

• Average commission rates paid to each broker.

• A description of the services purchased from each broker.

• The monetary value of these services.9

• Justification for any divergences from planned allocations (the difference between commissionsallocated and commissions actually paid).

SHOW HOW PLAN BROKERAGE DOLLARS ARE SUPPORTING CLIENT OBJECTIVES

In addition to showing how costs are minimized, it may be helpful to show clients how the brokerageexpenditures are directly benefiting their plan. Because costs can never be completely eliminated, plansponsors should see the connections between their investment strategy and their fund’s expenses.Clients should understand, for example, that their index fund is not cross-subsidizing another client’sgrowth fund. Concrete examples are often well-received.

In an environment of increased public scrutiny of investment management, there are a number of stepsadvisors can take to ensure that the money they oversee incurs the minimum amount of transactioncosts. While these costs will never be completely eliminated, reducing them can lead to higher netreturns for the end investors—the individuals that the plan sponsor represents.

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APPENDIX: INSIDE IMPLEMENTATION SHORTFALL

Implementation shortfall can be thought of as the difference in value between a paper portfolio and anactual portfolio. Assume an investment manager conceives an investment strategy that requires thepurchase of 1,000 shares of XYZ. On the day that the buy list is sent to the trading desk, a paperportfolio is created valuing the 1,000 shares at an agreed-upon benchmark price —for example, theprevious day’s closing price. As each purchase is made, the portfolio is revalued at the actualtransaction price, taking account of fees and commissions. When the process is complete (or abandonedbefore all 1,000 shares are acquired), the value of the actual portfolio is compared to the paper portfolio.The difference is implementation shortfall.

Transaction costs fall into three major categories:

PAYMENTS TO BROKERS AND DEALERS

Trading intermediaries like brokers and dealers are paid through commissions and spreads.Commissions are explicit fees paid to agency brokers, typically quoted in cents per share in the U.S.Institutional commissions range widely from less than one cent per share to six cents per share,depending on broker and trade; the average is about five cents per share.10 Instead of a commission, thebroker-dealer may be compensated by the spread. The dealer buys at one price (bid) and sells at a higherprice (offer), capturing the spread between the two. This is a cost to the dealer’s customers — the sellergets a lower price, and the buyer pays more, than if the two met directly. In one 1993 study, U.S. equityspread costs averaged seven cents per share; decimalization has subsequently sharply narrowedobserved spreads, though research on realized spreads is more ambiguous.11

MARKET IMPACT

Market impact measures the effect of the trade itself on a security’s price. By the law of demand andsupply, a large buy order will raise the price of a security, and a large sell order will depress it. Marketimpact is frequently described as the price concession that needs to be made to get the trade done.12 Ifthe other side is a dealer or a broker proprietary desk, rather than an end-investor, market impact mayblend with spread costs. Traders manage market impact by breaking orders down and trading them overseveral days — that is, by concealing information about the size of the order. The risk is that the marketprice will move against the trader over that time, in which case a timing cost is incurred. This is reallyan opportunity cost; the potential return lost to delays (or cancellations) in execution.

OPPORTUNITY COST

Opportunity cost results from delaying execution to lessen market impact, or not being able to makethe execution at all, or abandoning part of it because the market has turned against the strategy (eitherbecause of broad market trends or because the market has recognized the value of the strategy). If aninvestment manager’s strategy envisaged the purchase of 100,000 shares, and only 50,000 werepurchased, the lost potential returns on the remainder represent opportunity cost.

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NOTES

1. Andre F. Perold, "The Implementation Shortfall, Paper vs. Reality," Journal of PortfolioManagement (Spring 1988). The concept was used earlier by Jack Treynor, but Perold’s paperpopularized it. (Jack L. Treynor, "What Does it Take to Win the Trading Game," FinancialAnalysts Journal [Jan-Feb 1981]).

2. Securities and Exchange Commission, Request for Comments on Measures to ImproveDisclosure of Mutual Fund Transaction Costs; Proposed Rule (December 24, 2003). Also,Wayne Wagner, "Cost versus Liquidity: The Quest for Best Execution," AIMR Publications(2003).

3. Costs also vary according to factors like market capitalization, trade size and marketconditions — for example, small trades in large-cap stocks in neutral markets should incursmaller costs than large trades in small-cap stocks in adverse market conditions.

4. John C. Bogle, "Whether Markets are More Efficient or Less Efficient, Costs Matter," CFAMagazine (Nov-Dec 2003). Bogle figures the total cost of financial intermediation in the U.S.equity market — money management fees, transaction costs, custody charges, etc. — to besome $300 billion annually or "nearly 3% of the value of that $12 trillion market." If ourestimate is correct, transaction costs would account for about a third of total intermediationcosts.

5. David J. Leinweber, First Quadrant — Investment Management Reflections (1994). Leinwebernotes that some of the shortfall is attributable to the brief delay Value Line imposes on itsfund to avoid trading ahead of its subscribers, i.e. opportunity costs.

6. Disclosure of Order Execution and Routing Practices, Securities and Exchange CommissionFinal Rule No. 34-43590 (17 November 2000), at http://www.sec.gov/rules/final/34-43590.htm.

7. Association for Investment Management and Research, AIMR Trade Management Guidelines(2002), available at http://www.aimr.org/standards/ethics/tmg/index.html. Note that seekingto "maximize a client’s portfolio" is consistent with an implementation shortfall view of bestexecution.

8. AIMR Trade Management Guidelines, supra. These characteristics of a best execution brokerare based closely on the Guidelines.

9. Third-party services like research from independent providers can be valued by soft-dollarinvoices submitted by those providers for the broker to pay. The value of the broker’sproprietary services, like in-house research, would need to be carefully estimated.

10. Securities and Exchange Commission, supra.

11. Wayne H. Wagner and Mark Edwards, "Best Execution," Financial Analysts Journal (Jan-Feb1993).

12. Stephen Berkowitz and Dennis Logue, "Transaction Costs: Much Ado About Everything,"Journal of Portfolio Management (Winter 2001).

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©2004 Instinet Group Incorporated and its affiliated companies. All rights reserved. This document may notbe reproduced, in whole or in part, without the prior written consent of Instinet Group Incorporated.Instinet, LLC, member NASD/SIPC, branded as Instinet, The Institutional Broker, and Lynch, Jones & Ryan,Inc., member NASD/SIPC, are subsidiaries of Instinet Group Incorporated.

ABOUT INSTINET, THE INSTITUTIONAL BROKER

Instinet, The Institutional Broker, is dedicated to serving the professional investment community,including mutual funds and plan sponsors, around the world. Our products and services—designed toimprove trading efficacy and investment performance—include:

• Direct, efficient and unbiased access to the global equity markets, as well as the opportunity to tradedirectly with other Instinet clients.

• Sophisticated trading expertise and advanced technological tools, including intelligent order-routing,designed to facilitate the management of increasingly complex global equity trading strategies.

• Unconflicted trading based on a pure agency business model.

Through our electronic platforms, our customers can access over 40 securities markets throughout theworld, including the NYSE, NASDAQ, and stock exchanges in Frankfurt, Hong Kong, London, Paris,Sydney, Tokyo, Toronto and Zurich. We act solely as an agent for our customers and do not tradesecurities for our own account or maintain inventories of securities for sale.

Instinet has always been committed to best execution, and therefore is in a position to be the broker ofchoice for plan sponsors and investment managers seeking to fulfill their fiduciary duty to the fundsthey oversee. With Instinet, our clients can have confidence and trust in our agency brokerage becauseInstinet has no other interests—proprietary trading or research, IPO responsibilities, or other bundledservices—that could compromise the integrity of the trade. Costs are straightforward and reflect onlythe value of the services rendered.

Lynch, Jones & Ryan (LJR), an affiliate of Instinet, is one of the largest providers of commissionrecapture services in the world. By utilizing commission recapture, clients can unbundle executioncosts from research costs, pay only for execution, and reduce the effective transactions costs.

Finally, Instinet’s advanced trading research allows the client to perform pre-trade and post-tradeanalysis, determining the method and venue of execution that best fits the specific needs of the fundat that time, establishing a benchmark, and then measuring the quality of the trade at its completion.

Instinet, The Institutional Broker, is a subsidiary of Instinet Group, which is part of the Reuters familyof companies.

Instinet Group Incorporated • 3 Times Square • New York, NY 10036 • www.instinetgroup.com

For more information please contact your

Instinet Group representative or visit us

online at www.instinetgroup.com.