In the first of our exclusive bi-monthly Buy-Side Perspectives series, DAN ROYAL, global head of equity trading at Janus Henderson, dives into detail about what Best Execution means to him: including the importance of regulatory definitions, the multi-layered metrics of the practitioner perspective, and how his firm addresses the unique complexities of the concept.
The term ‘Best Execution’ is both a key guiding principle and a regulatory requirement within the trading arena of asset management. The responsibility applies to all parties involved throughout the trade execution process, both buy-side and sell-side. The regulatory definitions of Best Execution set forth by agencies, such as the Securities and Exchange Commission in the US (SEC) and the Financial Conduct Authority in the UK (FCA) outline the obligations and expectations for market participants. They emphasize the importance of taking all reasonable steps to obtain the best possible results for clients, considering factors such as price, costs, speed, likelihood of execution, settlement, and any other relevant considerations. These definitions provide a framework for market participants to adhere to and ensure they are meeting their regulatory obligations to seek the best outcome for the client.
From a practitioner perspective, the process for seeking Best Execution is comprised of many layers. Too often, however, Best Execution is viewed with a narrow lens as just an outcome. While outcome is important in the evaluation of an effective trading process, it doesn’t reflect the scope of effort and variable factors to be considered that lead to that outcome. The best result cannot be defined by a single or limited set of metrics. Additionally, each individual order and the corresponding series of market conditions are unique events, often diluting the validity of comparing the outcome between orders. Considerations such as broker, channel and tool selection, portfolio manager intent, participation levels, price points of engagement and street conversation are just some of the facets of an order implementation strategy that will impact the success of the trade. There is no singular script or sequence to effectively manage a broad scope of security characteristics, liquidity demands, order instructions or market conditions, requiring market participants to analyze those conditions to optimize their trading strategies and tool usage accordingly.
The practical implementation of seeking to achieve Best Execution is a process that occurs before, during and following trade implementation. It requires utilization of an effective platform with a continually optimized toolset, managed by seasoned trading professionals that possess a thorough understanding of market and liquidity characteristics. Only once these components are in place can these professionals freely navigate that optimized toolset in a manner that best suits the portfolio manager’s intent.
Three critical components in the Best Execution process are: channel, broker and tool selection. Channel selection represents the distinction between high touch, algorithmic (algo), crossing network and program trading. Each generally has an assigned execution commission rate and possess their own unique contribution or risks to a successful implementation of the investment decision. High-touch channels employ the skills and assistance of a broker’s sales trader to navigate the potential block liquidity opportunities within their firm. This may require coordinating transactions with other clients or liquidity from their firm’s risk book. Algo channels utilize the broker’s electronics trading tools to access the market in a predetermined and complex series of actions, with little or no human intervention. Crossing networks match mostly buy-side clients in an anonymous fashion, generally by securely scraping the trader’s blotter and alerting them to contra liquidity, with an option to facilitate a transaction, often in block form. Lastly, program trading, while similar to high touch, focuses on managing baskets of multiple securities, often with specific cash or geographical management requirements. The knowledge and experience of the trading team is a critical component of proper channel selection, often utilizing multiple channels in a single order if needed.
Another key component of the Best Execution process is broker selection and with that, the selection, optimization and utilization of broker inventory. Not all brokers are created equal, and their order handling skills can significantly impact execution quality. Becoming a broker dealer requires significant financial, philosophical and analytical investment. Firms that differentiate themselves often have astronomical costs associated with developing and maintaining effective electronic platforms that provide market access. This investment extends across multiple asset classes and channels of liquidity, resulting in larger firms possessing the potential for significantly superior capabilities.
However, it is important to note that the size of a broker does not necessarily guarantee a differentiated nor superior outcome. Firms of all sizes can differentiate themselves, but it requires focus and commitment to a vision. Additionally, a broker’s decision to rent versus own can play a crucial role in broker partnerships. When a firm can develop, innovate and customize products to suit their clients’ needs, there is a higher probability of providing a differentiated experience. On the other hand, firms utilizing white-labeled algos from another provider may limit development flexibility and an ability to optimize product for that client. White-labeled offerings are often generic in nature and generally structured to minimize costs for the provider. This limitation can potentially bypass suitable liquidity opportunities and emphasize more toxic liquidity to lower market access costs. As a result, there may be a decrease in liquidity capture and an increase in adverse price movement caused by the firm’s footprint in the market.
Tool selection is the utilization and optimization of products embedded within a firm’s Execution Management System and represents the delivery mechanism of each individual order slice to the market. It focuses on the distinction between products within each of the channels. In other words, which algo, crossing network or high-touch broker is suited for the situation. The combination, sequence and timing of the tool usage will have a significant bearing on the ability to successfully navigate the order’s liquidity needs. Philosophically Janus Henderson traders attempt to utilize a 4M principle as a guidepost in designing and optimizing our toolsets. Those principles guide the approach of an attempt to maximize our ability to capture favorable liquidity, minimize adverse price impact because of our activity, maintain our anonymity in the market and mitigate our exposure to predatory participants, as best suited to the intent of the investment decision.
While these factors do not define the urgency, participation levels or market impact, they do help shape the intent and design of the product when shares are actively placed. Particularly in the algo space, with the complexity of electronic trading tools, optimizing their usage is crucial in achieving Best Execution. These tools involve an intricate interplay of decisions between the algo scheduler (determining what portion of the order gets routed and how it is presented) and the smart order router (SOR), which determines the venues to route orders to and the sequence of routing. The combination of these decisions can result in an endless formula of combinations, and an inferior calculus of decisions can lead to significant underperformance in achieving the 4M philosophy.
With a team of experienced professional traders operating on what would be considered a best of breed platform to navigate nearly any situation, the ability to effectively manage the liquidity needs of the investment decisions is in place. Traders will then assimilate a broad scope of data inputs to employ and continually assess their trading strategy, including indications of interest, trade adverts, volume, price action, volatility, relative market performance, news and events, and this is by no means an exhaustive list.
As mentioned, using a limited set of quantitative metrics falls short of determining successful implementation of Best Execution. To achieve Best Execution on the buy-side, several components and factors need to be considered. Quantitative factors play a crucial role and often involve the use of trade cost analysis metrics. These metrics can include implementation shortfall, which measures the cost difference between the decision to trade and the final execution, implementation shortfall versus expected impact, interval volume-weighted average price (VWAP), reversion, order size as a percentage of average daily volume, urgency, and the assessment of market momentum in the security and broader market. These quantitative factors provide a data-driven approach to helping assess the quality of execution and evaluating the performance of trading strategies. Yet these are only part of the equation. Assessing qualitative factors also play a key role in the assessment of Best Execution. Items considered are the distribution of activity across trading channels and broker usage among the trading team. Providers are evaluated on their ability to service the trading team, their order handling skills, liquidity provision and general level of expertise in aligning their offering with the needs of the trading desks.
Specifically, in the algo channel, optimization can be a complex undertaking. To address this complexity at Janus Henderson Investors, we utilize a process of categorization and comparison. Categorization involves the implementation of a well-defined series of algo brackets designed for each region, where each bracket represents a unique toolset possessing its own characteristics and expected outcomes. These brackets can be defined based on characteristics such as dark aggregation, aggressiveness, schedule-based trading, closing-focused strategies or small-cap strategies. This comprehensive range of brackets forms a complete toolset to navigate various orders and trading conditions effectively. The characteristics of each bracket are shared with broker partners to guide them in developing customized products for each bracket. While the responsibility for custom enhancements lies with the broker developer, traders will have a limited ability to alter some components within the bracket. This approach allows for a comparative function built into the platform, enabling constant side-by-side evaluation of the tools.
By employing a combination of qualitative and quantitative assessments, the team can gain an understanding of the components that lead to differentiated outcomes. This knowledge enables focused conversations with the providers to continually optimize product performance. Discussions may revolve around adding or eliminating venues, incorporating minimum fill quantities, or considering representation within the bid/offer spread, among other development logic. The optimization process ensures that the tools utilized align with the overall objective of achieving Best Execution.
Achieving Best Execution for the buy-side involves understanding the regulatory definitions set forth by jurisdictional agencies, as well as the practical components of implementation. It requires considering both quantitative and qualitative factors, such as trade cost analysis metrics, market conditions, trading channel usage, and the expertise and investment of broker partners. Best Execution is an ongoing process that involves the selection, optimization and utilization of broker inventory. Additionally, tool optimization plays a crucial role, employing categorization and comparison to evaluate and enhance performance. By considering all these factors and continually striving to optimize execution quality, buy-side firms can meet their obligations to seek the best possible outcomes for their clients.
The opinions and views expressed are as of the date published, are subject to change and may not reflect the views of others in the organization. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use.
Janus Henderson is a trademark of Janus Henderson Group plc or one of its subsidiaries. © Janus Henderson Group plc. C-0723-50936 07-30-24
The BEST EXECUTION Buy-Side Perspective series offers unique opinions and insights from leading heads of desk and industry experts: discussing, on a bi-monthly basis, the key topics and issues affecting the buy-side right now from a practitioner perspective. Check in next month for a fresh look at automation and innovation across the buy-side from our next mystery contributor…
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