FEBRUARY 24, 2021

Impact and the Total Cost to Trade

We were recently asked to examine whether large fund managers, or those executing large trades, were disadvantaged by disproportionate trading costs. We estimated the impact cost of our US algorithmic trades in H2 2020 and showed that cost rises with urgency and order size. This is mitigated however, by slowing down the rate of participation and by lower volatility, which is a common characteristic of larger capitalized stocks.

The literature on the subject includes Frazzini, Israel and Moskowitz’s 2018 paper on trading costs1, which was highlighted in a recent article in Yale Insights by Moskowitz2. The research team examined trading data over a 19-year period across 21 developed markets and concluded that trading costs for large institutions were significantly lower than the traditional literature suggests. Other conclusions were:

  1. Impact cost dominates the full costs of trading, including both spread and commissions

  2. The higher the number of venues accessible for a trade, the lower the impact cost

  3. The more intraday triggered auctions, the higher the impact cost

  4. Impact rises with volatility and is larger for smaller stocks

  5. The size of trade, or % ADV, is the most important cost variable and there is a non-linear relationship between cost and order size

The researchers concluded that the cost to trade approximated a square root function of order size. The data covered a single buy-side institution executing trades separately from the portfolio management process. It was however, crossed-checked against reported trading costs for two leading US exchange-traded funds, and the model built from the researchers work accurately predicted the costs reported by those funds.

The execution strategy of the institution is to spread out large trades and rest passively using limit orders to control the pace and cost of trading. In this report, we review Liquidnet’s trading data for H2 2020 and discuss the use of dynamic scheduling as an alternative means of controlling costs when trading.