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ffisffi ,6 *"ffi#*ffiffiffiw& fiqwp%g%w*#;x;;w ffis*w*-spayne H. Wagner, PartnerEdward C. Story, PartnerLarry J. Cuneo, PartnerMark Edwards, AssociateMichael Keady, AssociateRosemary Tribulato, AssociateSERVICES PROVIDED TOInstitutional InvestorsInvestment ManagersInstitutional TradersPlan Sponsors

ALPHA CAPTURETM CASE STUDY:EVALUATING PAYMENT.ORIENTED BROKERAGECOMMENTARY #30January 1991

Plexr developed ALPIIA CAPTURE_ to help investment managers q4ptule theintrinsic value of Portfolio Manager decisions into client portfolios. This casestudy is drawn from a recent report to one of our clients. It illustrates howinvestment managers use ALPILA CAPTURE to fine-tune their investmentmanagement process through careful identification of broker skills.

he::ProblemThe manager's tradedesk believes that bro-kers selected for non-traditional research maynot handle trades withthe same skill and effec-and execution-orientediveness as full-servicebrokers.

The investment manager wants answers to thesequestions:1. Is the perception correct? Are there detect-able differences in broker skills? Do thedifferences apply to whole classes of brokers,or only to specific brokers?2. Can broker skills be objectively measured,considering differences in trade difficulty,order instructions, etc.? Can trade costmeasurement pinpoint problems for thedesk's monitoring of the brokers?3. How can the manager establish damagecontrol so that problem-broker trades do nothandicap client interests? How are tradingdeficiencies best communicated to the prob-Iem broker so he can improve trading effec-.,tiveness -- to the benefit of manager, sponsor,and broker?

EVideneCThe graph below is takenfrom the Alpha Capturereport. It shows the com-mission and impact costs ofactual trading with specificbrokers. Impact is measuredfrom the price/time at which the broker receivesthe order. It represent the true cost incurredwhile the broker was in charge of the order.Impact costs clearly dominate commission costs.

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The diagonal line across the chart shows a mea-sure of difficulty. Order size, stock liquidity,market direction and the degree of urgency allaffect Alpha Capture's difficulty measure. Bro-kers handling easier trades sort to the right.Note that broker #8, a payment-oriented broker-age firm, incurred the greatest impact. Nextlargest impact comes from broker #1, a fullservice broker. (There is no systematic effect bybroker type.) The table below compares thetrading done by these two:

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# ordersAvg shsBroker #84720M

Broker #17T45M

Vo of.vol 2A% 36%Difficulty (1=easy) 2.5 3.1Days to complete 0.36 0.51The Sharpe-Grossman formula for the ThomasLoeb trade cost data imputes theoretic cost.Broker #L had more difficult trades to handle,yet executed them at lower cost than Broker #8:

C6ncluSionSThe results are not en-couraging. Broker #8 ismore costly to use for alltypes of orders exceptthe trivial (less than 1000shares!) working orders.

Broker #8, receives significant commission busi-ness to pay for valuable services. Yet they tradedworse than any other broker, even though thetrades handled were much easier than average.There is an additional secondary effect: brokerswho do a good job are concerned about "liquidityskimming"-- the deliberate feeding of easy ordersto less qualified brokers. And they are right!Services purchased through Broker #8 arepaid for many times over: with the commission,plus through a performance penalty averagingnearly 150 basis points on every trade made!

ChangesPoor broker performanceIeads to poor investmentperformance. Thispenalizesboth the investment manag-er and the plan sponsor.There is neither business orfiduciary justification for using a less-than-ade-quately-skilled broker. Either a broker has todeliver execution services comparable to otherbrokers. or he should not be used.

A conscientious broker will respond to theseclient analyses by working to improve proce-dures, personnel, and correspondent relation-ships. The goal is not punishment, but positivechange to align the quality of the executionservices to the trading needs of the manager.True "bestexecution"cannot be defined as a sim-plistic cents/share commission. Sewices pur-chased through commissions must be justifiedboth on the value of the research and the excel-lence of the execution. A manager who fails toperform either test compromises bothhis fiducia-ry responsibility and his investment performance.

-w.w.

(c)1991, Plexus Group, A General PartnershipYou are welcome to reprint quotationsor extractsfrom this material with credit given to PlexusGroup, 606 Wilshire Boulevard, Suite 310, SantaMonica CA 90401. Tel. (213) 451-5075.

Theoretic cost -1.2VoActual cost -Z.I%Cost ratio I.jX'1.87o-7.4%0.8x

The desk considered Broker #1's execution skillssatisfactory for the more difficult/delicate mix oforders. By any absolute or comparative stan-dard, however, Broker #8 appears to incurexcessive transaction impact.A key factors in transaction costs is the speed oforder completion. When time to completion isthoughtto be critical to the success of the trade,the manager must be prepared to "payup" for theliquidity demanded.Trade instructions communicate trading urgencyto the market. Market orders and principaltrades, which rely on the specialist or broker toprovide liquidity if none is available, convey asense of urgency. Working or limit orders, incontrast, indicate a willingness to wait for lowercost natural liquidity. The trader thereby signalsthat he or she is more price-impact sensitive thantime sensitive.The table below summarizes the trade orders sentto Broker #8. The figures below Broker #8 dataare the averages for all brokers used:OrdersAvg shsConclusion:Vo volConclusion:

Market Work Limit2041020M 1M 30M(40) (15) (s3)Easier25Vo 0.3% 70%(20) (2e) (2e)Easier

Theoretic cost -1.4Vo -0.4% -0.9%Actual cost -2.4% -0.1% -1.2VoCost Ratio 1.8X 0.3X t.4X(0.s) (0.7) (0.3)Evidencs Much more costlv