I am using Schweser so I might have missed something but I hope if anyone can explain me the logic or rather justify the logic here.
During the calculation of Implementation shortfall, they encourage to adjust for the market movements. Thus, the implementation shortfall would exclude the effect of the market movement during the execution period of the trade, thus to (arguably) better reflect the cost of the trade.
However, I fail to see the vadility of such correction. The point of a good execution that one should perform it timely. If by giving unrealistic limit orders, the actual trade (assuming the we are buying) would be at a higher price due to the market movement, shouldn’t we consider it as a cost anyway, precisely a slippage cost (delay)? If one would not be judged my the market movement, he would just keep giving low limit orders until it actully filled at some very later point in time. Am I wrong here?
Let’s say your stock trades in the S&P500 and has a perfect Beta of 1. You decide on sunday evening you want to buy the stock for $50.00 monday AM. The stock opens at 50.00 and the S&P 500 rallies .1% immediately at open. Your stock has also rallied 1% and is now trading at 50.50 and lets say it cost 100bp to implement this trade when the market opened.
In implementation shortfall you would use your execution price - benchmark (decision point) as a component of your implementation shortfall. However, since the general market rose 1% and your stock has a perfect beta of 1 your actual market adjusted shortfall is -1% since the market moved up, offsetting some of your implementation costs.
Therefore your total implementation short fall is 0% (100bp to implement - 100 BP movement in stock price)
However let’s consider adjusted scenarios. You want to buy 1 stock of a company. Let say the closing price at the end of Friday is $51.00. You want to buy it for $50 on Monday morning. Your stock (beta of 1) rallied to $52.00, your order is not filled at the day closing. You now moved to limit order to $51.00 but the next day it moved up to $53. You again move your limit order to the $52, below the market ask. Let say after chasing it for 5 days, it moved to $56 and you finally managed to buy it at $56.
Gain on paper portfolio = $56-$51 = $5
Gain on real portofio = $56-$56 = $0 (lets exclude commssions for the sake of simplicity)
Total IS = $5 - $0 = $5, in percentage $5 / $51 = 9.8%
Lets assume that total movement of the stock all due to the market movement:
This essentially saying that the trader even with giving unrealistic limit orders for 5 days is not responsible for the cost of the implementation, even though he could have enjoyed 9.8% of portfolio return if he bought it on Monday with a market order?
I don’t know how the unrealistic order entries play into this. The movement from when a trader decides to buy and when they actually buy should not include relative market movements (market appreciation * Beta) when you are using this metric.
It’s purely to capture the other costs to aquire stock. Commisions, fees, taxes, slippage from Bid/Ask spread, opportunity costs etc.
I agree with unemployed. The same confusion is with me. How come the investor is considered a beneficiary of a positive market movement when he did not buy the stock initially when the price was lower. Can anyone please explian? S2000magician’s explanation may be satisfactory here. I also saw other threads in thie forum discussing this issue but no one seem to explain it properly.
It adjusts the shortfall to the increase in the market, to make traders comparable in different market enviroments.
For example, if your traders shortfall is 100bps, and the market rallied 20%, and another trader had a shortfall of 50bps but the market dropped 5%, does this make your trader worse because the shortfall was higher? This is why we could use market adjusted shortfall to determine favorable trades. Good prices (low shortfall) doesn’t give the full picture. Good prices while prices are rising, does.
You compare the cost you incurred to make the trade, but in a rising market, the cost should be higher not to the trader’s inefficency. Thus you subtract the market movement from your shortfall. So it’s SfAR = Sf - Mr
I think i am getting what you are trying to say. But if you compare two positions, one position buying stock initially before appreciation and at low transaction cost and the other position later with high transaction cost and after the stock has appreciated. In the first position trader would have done better as compare to the other position due to low transaction cost and increase in the price of stock.