Execution consulting. It's the latest buzz phrase being tossed about between fund managers and broker-dealers. And it has nothing to do with getting advice on how to use the guillotine.
Instead, it refers to finding the best way for fund managers to receive low-touch (read: automated) trading with high-touch (read: personal) service from their broker-dealers.
For broker-dealers, their 'high-touch' time is spent advising clients on how to execute their orders. This covers which trading venues to use, when to trade and how much to trade. They will also execute the order, if asked.
For fund managers, 'low-touch' means low-cost. Automating execution of trades on an exchange or alternative platform means lower transaction costs.
Based on estimates by research firm Tabb Group, more than 50% of equity trades are now done through algorithms, program trading or other computerized means. So clients shouldn't need any handholding if computers do all their thinking right? Not exactly.
"At its core, execution consulting means helping clients improve their trading strategies to drive performance," said Laurie Berke, a principal at Tabb Group who just wrote a report on the topic entitled "Execution Consulting: The Next Generation in Sales Trader Coverage."
Berke didn't highlight any firms in her report but often cited by fund managers in New York contacted by Money Management Executive were Bank of America Merrill Lynch and Bloomberg. Others were technology providers such as Tethys Technology and TradingScreen, which tout their independence from broker-dealer ownership as making them best positioned to providing execution advice.
Execution consulting really isn't all that new. As Matt Samelson, managing principal at research firm Woodbine Associates in Stamford, Conn., pointed out, fund managers have always wanted to work with broker-dealers who understood direct market access, algorithms and trading strategies.
The difference: It's broker advice redefined for current market conditions. With Regulation National Market System in the U.S. and its European counterpart Markets in Financial Instruments Directive creating new alternative trading platforms and algorithmic trading, fund managers are a lot more demanding of their broker-dealers.
"In the current fragmented market where the buy-side trades much of its order flow through algorithms, the consultative process involves far more quantitative analysis of market structure, liquidity, trading performance and recommendations on how to use broker-provided tools to achieve desired results," Samelson said.
Broker-dealers may be expert at trading but that expertise comes in two forms. Often called the "flow guys," the high-touch traders can spout out plenty of advice on which stocks fund managers should buy based on their firm's fundamental research. At best they might even know at what price to buy the stock.
Low-touch traders who work on an algo desk can explain in great detail how each algorithm works and when each should be used. There are dozens of broker algorithms and the wrong choice of trading strategy can result in costly leakage of trading information into the market, which can increase the costs of buying or selling shares.
What do fund managers want to know? Almost 50% of fund managers surveyed by Berke said it was advice on effective use of algos.
"When the answer to the question 'How can your sell-side trading coverage help you?' is 'advice on the use of algorithms,' you know the buy-side client is asking for help that he is not getting today," Berke said.
Being an execution consultant is no easy task. The first requirement is analytical skills and "the intellectual curiosity" to delve deeply into the market and trade data to uncover better trading strategies," Berke said. The second requirement will be the ability to use knowledge of market structure combined with an understanding of the customer's trading style to develop a methodology to support consistent, repeatable successes in execution.
Translation: Brokers need to know their customer, their algorithms and how to apply the optimal trading solutions to each client's trading style.
Tethys has eight execution consultants on its team all of which were either former quantitative portfolio analysts or algorithmic trading analysts.
"It's a lot more sophisticated than just crunching results for transaction cost analysis," said Nitin Gambhir, chief executive officer for Tethys in New York. "The numbers themselves don't mean anything if you can't leverage the data and recommend an actionable plan to clients to improve their performance. You don't want them lost in all of the minutia of details."
Handholding aside, the key differentiator between brokers, as always, is the bottom line. How much additional return can one generate for the fund manager.
"When a head trader on a buy-side trading desk can look at his [sell-side] trader's execution results and measure positive relative performance from one broker to another, then he will not only have identified the best tools for the trade but the best advisors in the use of those tools," Berke said.
The benefit to broker-dealers: "If an electronic trading execution advisor can deliver research, ideas and service in electronic trading, and help preserve or even generate alpha, buy-side traders will pay for it," Berke said.
"While sales traders are sharing their commission rate with allocation for research, the portion of that rate that pays them for their skills and their service is higher than the portion that is allocated for an algo and smart order router," Berke said.
Just how much? High-touch service lays claim to 64% of the bundled commission rate, which covers the higher-priced advisory services and the lower-cost execution of trades through algorithms, smart order routers and analytics. In effect, service equals premium pricing.
Case in point: for year-end 2010, the bundled rate on algorithms-the rate paid for algorithms and research attached-was $0.0168 cents per trade and the rate to execute the order only was $.00083 trade. That means the payout for algorithmic execution services came in at less than 50% of the bundled rate. "What today's unbundled payout ratios show is the perceived value of high-touch coverage and its service model outweighs the value of standalone electronic trading technology," Berke said. "Add an execution consultant to the electronic trading picture and you now introduce the concept of service in a low-touch environment."
