Measuring Best Execution (Update 2003) Print E-mail
Written by C. Meyrick Payne in cooperation with Wayne Wagner, President of Plexus Group Inc. of Los Angeles   

The purpose of this Bulletin is help mutual fund directors wrestle with the difficulty problem of measuring bestexecution of share trades. Best execution is major topic during routine SEC examinations and, in many cases, a difficult topic for mutual fund boards.

Directors often ask each other "why are we paying as much as 6 cents a share to make a trade when everyday I am bombarded with offers to effect a whole transaction for $19.95". Well of course, there are some good, and some not so good, reasons. This Bulletin presents a framework for mutual fund directors to analyze this issue.


First let's put the issue in perspective. Six cents per share on 100,000 shares is $6,000 when E*Trade is offering an entire trade for $19. Why? Well, principally because there is a difference between a small retail trade for an individual customer buying or selling 100 shares and an institutional trade of, say, 100,000 shares. E*Trade is unlikely to offer to buy or sell a 100,000 share block instantaneously because the electronic crossing network (or ECN), essentially the market in which E*Trade deals, may not have sufficient liquidity to absorb such a big block in one bite. By definition a mutual fund deals in large blocks of shares. As a result an ECN trade may take several days to effect.

While waiting, real costs mount. The alternative is to have a full service broker execute the trade instantaneously, but to do so the full service broker must place its own capital at risk. Persuading the partners or executives to do this involves paying a higher commission.


The real cost of the trade is made up of three factors: the commission, the market impact and the cost of delay. The commission represents a handling fee and a reward for the broker, the market impact is the movement in the market once a large order becomes known, the cost of delay is the opportunity cost of not being able to use the money for something else while awaiting the trade to clear. The total cost is often represented by an iceberg with the commission forming the visible peak and the delay forming the great unseen bulk. According to the research firm, Plexus Group, in the first quarter of 2001, the year of the great run up in Tech stocks and IPOs, the iceberg looked as shown overleaf.

Thus the cost of trade was not really 4.2 cents, but rather 49.1 cents. The figures from Plexus indicate that the iceberg has different shape for different investment styles. For example in the first quarter of 2001, a large cap value trade had a real cost of 55 basis points. For small cap value, a real cost of 84 basis points. These total costs seem high in late 2001, but remember that the opportunity cost of missing the market or feeling the impact of a large trade exists in a bear market as well as in a bull market.

The potential lack of liquidity in the market is not just a problem when stocks are rising as they were in 1999 and early 2000. At that time stocks were in short supply. In a down market, buyers can be in short supply. The differential between the commission cost of a trade and the real cost is just as likely to exist.

Selecting the appropriate broker route is more complicated than just comparing the commission rate. Certainly choosing an ECN, like Instinet, is cheaper in commission, but not necessarily in total cost. In addition there are some other potential drawbacks, such as limited liquidity, no research availability, and execution only on the Instinet network. Nevertheless ECNs improve everyday with improved liquidity and ever-larger networks.

Now we come to the tricky business of measuring best execution. One specialist firm, Plexus Group, gauges each trade against a standard benchmark called PAEG/L, which stands for Plexus Average Execution Gain/Loss. PAEG/L answers the question: "What did it cost the most experienced buy-side trade desks, using all the skills available to them, to execute an order of similar characteristics?" Note that the emphasis is on Order — because trades are often small parts of much larger orders that require the balancing of market impact and timing delay.

Here is an actual example of PAEG/L for the purchase of 250,000 Tech shares traded on NASDAQ in the hot market of early 2003. The total cost was 169 basis points or 84.5 cents on a $50 share. If the trader for a mutual fund were able to affect this purchase for 6 cents per share with a full service broker who put their own capital at risk to facilitate the trade, the fund shareholders benefited.

On the other hand, there are many small trades made where an ECN is absolutely the best place to make a trade. Only an expert can tell. Fund directors need to seriously consider retaining the services of a specialist consultant to ensure that fund shareholders obtain best execution. Deciding on the basis of commission rates is misleading at best and dangerous at worse.

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