Trade execution – art or science?
20 November 2019 | Paul Jakubowski
Each year, over US$77.8 trillion of global equity trades are made on average. A common misconception is that all of these trades are done by robots or complicated formulas. But the truth is, it is still very much a human function – a combination of art and science.
It seems logical to want to get the best execution possible when placing a trade, and it can make a real difference to end investors. Why? Put simply, because proper trade execution can dramatically improve the performance of both index and active funds, and ultimately save investors money.
The problem is, there are many different ways to trade. For example, we have seen a move from on-exchange towards off-exchange equity trading over the last few years, as the graph below illustrates.
Source: Instinet & Vanguard. Please note that almost all EIG trades are executed via algorithms. On-exchange refers to transparent trading venues whilst Off- exchange refers to non-transparent trading venues.
So how does trade execution actually work? When considering the best way to execute an equity or bond trade, the first thing traders asks themselves is: How am I going to find the best price and the most liquidity? Through competitive or negotiated trading?
Competitive trading is when traders engage several counterparties (usually banks) in order to get multiple prices. This is the most widely used method of execution, but it can also be a risky strategy because it reveals information about your intentions to market participants. For larger trades, this can have a negative impact on your position by “moving the market”. This is especially true in the equities market, where certain regulations, such as the MiFID II Directive, have encouraged increased transparency.
Negotiated trading, on the other hand, is more of an art. This involves the trader going directly to a counterparty, or multiple counterparties, in search of the most liquidity and the best price without having such a large market impact.
The next question is: How involved in the trade execution do I want to be?
There are three main options: algorithmic trading, outsourcing execution to a broker or executing the trade yourself.
- Algorithmic trading – this is where the science comes in. In its simplest form, a trader puts a trade into a system that uses a formula to execute trades over time, depending on factors such as the number of orders, volatility and price movements. This is a very low-touch execution type and is highly systematic. It is often used for more widely held, liquid securities that are traded in smaller order sizes.
- Outsourced execution – this has slightly more of a human element. Here, the trader gives the trade to a broker (usually a bank) to execute as they see fit to get the best outcome on the trader's behalf.
- Executing yourself (auto-execution) – this is the art. This approach involves the most interaction, and is used for more illiquid securities and bigger trades.
This brings us to the next consideration: Do I want to execute electronically or over the phone? And yes, traders do still use the phone sometimes!
Let's consider fixed income trading in particular here. If you decide to go the electronic route, you have to choose which platform to execute on; popular ones include Tradeweb, MarketAxess and Bloomberg. You then execute the trade using an approach known as request for quote (RFQ). This is where the trader shortlists a number of competing liquidity providers offering the most competitive price for the bond. The trader then simply clicks on the best price and the trade is done. A recent evolution in this type of trading, called “all to all” trading, has buy-side firms trading with each other.
Auto-execution is a further extension of electronic execution. This approach doesn't require the trader to enter any trade information at all on the trading platform – it simply flows directly from their portfolio management system and the platform automatically selects the best price. The trader defines the parameters under which they are happy for the auto-execution to happen in their platform preferences. This method is increasingly prevalent – the graph below shows how the use of this trade execution type by our fixed income team has almost tripled. As with algorithmic trading, this is often used for more widely held, liquid securities that may be traded in smaller sizes.
Phones are not used as frequently to execute trades as they once were. But picking up the phone can still be very useful when trading illiquid securities or in volatile market environments. Phone trades are typically negotiated.
Source: Vanguard. Data as at 30 September 2019.
So why are there so many different ways to trade? The simple answer is that there are many different types of securities, investors and markets. Certain securities lend themselves to certain types of execution methods. Not all investors have access to the same markets, systems or technology. What's more, some markets are more developed than others or have rules that are better suited to different trade methodologies.
At Vanguard, we take steps every day to ensure best execution by continually evolving our trading strategies, leveraging our trading expertise and improving our use of technology. In aggregate, this means fewer errors and lower trading costs, all with the aim of helping investors keep more money in their pockets.
With contributions from Tafadzwa Chanakira, Christie Goncalves, Quentin Grulois, Sophie Hunter and Jon Tricker
Important risk information:
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.
Other important information:
This material is for professional investors as defined under the MiFID II Directive only. In Switzerland for institutional investors only. Not for public distribution.
This material was produced by The Vanguard Group, Inc. This article is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.
The opinions expressed in this article are those of the author and individuals quoted and may not be representative of Vanguard Asset Management, Ltd or Vanguard Investments Switzerland GmbH.
Issued by Vanguard Asset Management, Ltd, which is authorised and regulated in the UK by the Financial Conduct Authority. In Switzerland, issued by Vanguard Investments Switzerland GmbH.