Trading the close: too good to pass up? 

As trading conducted at or near the closing auction has increased, so have the potential benefits to a transition of participating, raising the thorny question of transparency? 

Thanks to a boom over recent years in passive portfolios, whose managers rebalance at the end of each day, the close of day auction now comprises 20% to 30% of daily equity volume in many markets.

“The closing auction has become a hugely significant liquidity event with active traders joining the rise in passive flow which has traditionally been done at the close. There is a well-defined, transparent price discovery mechanism and a lot of historical data to leverage. This can allow for a portion of trading and risk to be taken off the table at a single point in time, seemingly without any spread or impact,” says Paul McGee, head of Macquarie Capital’s transition management and portfolio solutions group in London.

Fixed income is seeing a similar effect. “On the fixed-income side, the growth of passive investments has encouraged the development of trade-at-close functionalities. Combined with the efficiency of portfolio trading, which enables significant risk transfer at a single point-in-time, the end-of-day is increasingly becoming a natural benchmark for implementing transitions efficiently,” says Cyril Vidal, head of portfolio transition solutions at Goldman Sachs.

Trading volumes are increasing prior to the close, too. “The increase toward the end of the day is associated with tighter spread, lower volatility – perhaps a quarter of that of the beginning of the day – and higher correlation – typically five-to-six times higher, especially in periods of crisis,” says Michael Steliaros, global head of quantitative execution services at Goldman Sachs.

But taking advantage of late-in-the-day or end-of-day liquidity creates a conundrum when it comes to measuring the costs of a transition, using the classic benchmark of implementation shortfall. In particular, when the benchmark used for the event shortfall is the closing price, trading prior to the close will always show up as zero – or even a minus cost.

“With the increasing share of liquidity in the closing auction versus continuous trading, the relative benefits of using an implementation shortfall benchmark could be called into question,” says Vidal.

“Say I buy 10% of the day’s volume at the close, then compare my transition using the resulting closing price as my benchmark. I can only have increased the price by my buying activity, but none of this impact will be recorded,” says Steve Webster, direct of transitions and trading solutions at MJ Hudson.

“If you trade and measure your transitions at the close, the implementation shortfall will always be zero. I could have paid a huge premium for transitioning but it will never show up as a cost. I’m gaming the [cost] measure.”

Hazards of a ban

Preventing transition managers from trading the close outright is a poor solution to the problem since it fences off a vital source of liquidity that could significantly reduce the total cost of a transition.

“In most global transitions, executing a very liquid slice at the close can help mitigate overnight risk or manage regional imbalances without compromising the transparency of the performance measurement,” says Vidal.

Ignoring the close may see major opportunities missed. “On a day you were trying to sell a large holding that added real risk to the transition – sure enough, 10 million shares went through at the close and we had to stand and watch. However, participation which disguises performance is difficult to justify,” says Webster.

Setting a transition’s benchmark using the closing price without trading puts the transition manager at an immediate disadvantage. “By using last night’s closing price, you immediately create a slippage from the gap between the market close and its subsequent opening. As a transition manager it is important to identify these risks and, where possible, manage them,” says Webster.

“Nowadays, we execute for clients across various benchmarks, not just implementation shortfall. It makes sense to maintain flexibility and offer options to clients when it comes to execution strategy rather than be pro or against any one option, like execution on the close,” says Artour Samsonov, head of transition management and investment solutions at Citi in London. “The trade strategy needs to consider transition profile in terms of risks and liquidity in the context of current market environment. Let’s be honest, nobody dumps the whole trade on the close - no client I know would ever agree to that”.

Hazards of trading the close

Besides the issue of measuring its impact on prices, trading the close also comes with other hazards. One concerns transitions that take in multiple time zones.

“Say you have a big net sell in Asia and a big net buy in US: the client would be way underinvested during the day. That’s a point that doesn’t come out in the numbers if you just compare a target close with an implementation shortfall measure,” says Craig Blackbourn, EMEA head of transition management, Northern Trust.

A transition manager selling securities in Europe and buying them in the US must consider which to keep back for the period in which both markets are open (typically 2.30pm to 4.30pm UK time).

Trading heavily at the close could also leave a portfolio unbalanced. “If you only trade the liquid bit of a portfolio at the close, you may inject a load of the risk in your residual. It’s not an easy path to tread,” says Andy Gilbert, EMEA head of transition client strategy at BlackRock.

This illustrates a fundamental asymmetry of risk for those using the close. To the index managers who drive the high end of day volumes there is no conundrum: they will always rebalance their flows; the resulting price is reflected in the fund’s closing price. But transition participants in the end of day auctions may become hostages to fortune.

“Closing auctions typically restrict certainty of price and/ or completion. A balanced transition may come unstuck if your sell orders are not filled, resulting in buying everything and selling nothing, effectively leveraging your client. Then you are left holding your hat in your hand,” says Webster.

In general, this is a resource that must be used with caution: poor end of day trading will leave the client at a disadvantage. “If you put too much into the close, you would see some reversion the next day. So, there are risks in there: it’s not a risk-free trade,” says Craig Blackbourn, EMEA head of transition management, Northern Trust.

Compensating measures

However, on balance, the benefits of providing some allowance for trading the close appear to outweigh the costs. And, while fogging up the measurement process under implementation shortfall seems a fair price to pay for a better outcome, transition managers should bring to bear other measuring tools to shine a light through the fog.

Measures include headline volumes, timing, participation and weighted average price. Which shed most light on the transition varies with its liquidity profile, the type of strategy and how urgent it was to execute. Individually these may lack the precision and simplicity of implementation shortfall, but taken in combination they go a good way towards clarifying the picture.

“While it’s difficult to match the level of transparency of implementation shortfall, which is an unbiased benchmark, advanced performance analytics and scenario analysis can provide more comfort to clients for choosing target close strategies and achieving an overall lower implementation cost,” says Vidal of Goldman Sachs.

Crucially, measures must provide an accurate picture after the event. “Any close trading should be accompanied by comprehensive and transparent reporting, giving details on actual participation rates and price moves, also comparing vs historical averages over a configurable timeframe,” says McGee.

“With trading volumes migrating dramatically towards the closing auction, the traditional approaches to evaluate transaction costs need to be revisited to include a specific measurement of on-close impact,” says Vidal.

Clients need to be made aware of the likely impact ahead of time. Transition managers must provide all necessary information to inform a choice, since often trading the close will not be appropriate.

“Certain trades lend themselves to a close trade strategy – such as when looking to simultaneously purchase against a pooled fund redemption priced at the close. Other transitions may be heavily skewed to illiquid names, where a close strategy could add little to no value once you cap your participation based on average closing auction volume,” says McGee.

Where trading the close does occur, the strategy must be clearly signalled to the client.

“It should be made very clear to clients what proportion of trading is proposed for the close, how this value has been determined, and how this compares with the average closing volumes in each security (stock specific analysis is very important),” says McGee.

“A good transition manager can predict the size of the exposure gap, explain if anything can be done to mitigate this and what this impact will be until the following day. This way, the contribution to the transition cost can be quantified, attributed or removed from the managers performance where cost that can’t be avoided,” says Webster.

“As a transition manager, you should find out what you could and should do at the benchmark point and explain what impact you’ll have at the close,” says Graham Dixon of Inalytics.

“In every case our role is expert and educator, providing the information for the client to decide what is best for them and their unique needs,” says Amanda Williams, regional practice lead for the Americas at Northern Trust in Chicago.

Managers should also consult clients for favoured solutions to handle delays, as when they must sell from one fund and buy into another which prices at a different time. “Do you sit out the market half a day or buy something to provide short-term market exposure, adding complexity for the transition?” says Graham Dixon of Inalytics.

For multi-region transitions a hybrid benchmark – combining the close in the US with an implementation shortfall in Asia, for example – can be useful.

Limits

Prevention being better than cure, one route favoured by consultants to constrain the market impact of trading the close is to limit how much of it can be done, using volume limits.

“(Consultants are) are coming round to the idea of allowing transition managers to trade at the close as long as the proportion of total volume is low. We recognise that the closing auctions are a valuable source of liquidity, but the practical way to use them is via a volume limit. And the key is transparency, where the costs of interaction with the close are made clear and not just assumed as a zero expense,” says Webster.

Limits should be agreed between transition manager and client in advance, based on detailed analysis of historical volumes in those stocks during the closing auctions and the varying volatility of such auctions.

They will vary with the size and dynamics of that market – what fits for Japan may not work in the US. “In most markets you can be approximately 10% of the closing volume. Between 0% and 10% you’re definitely not having an impact. Above 15% or 20% you are likely to influence,” says James Woodward, head of portfolio solutions, Asia Pacific at State Street.

Webster is more cautious: “we’d be hesitant to sanction anything beyond 2% of ADV”.

For their part, be comfortable that what they lose in transparency is outweighed by a better execution. “It’s up to those who advise the client to be comfortable the strategy is using liquidity as much as possible while also being as transparent as possible,” says Webster. In other words, the client needs the fullest transparency and expert advice to find the right balance. 

A wider problem?

Steve Webster, director of transitions and trading solutions at MJ Hudson says it is useful to distinguish the two sources of risk that will affect the cost of a transition. “The first, on which implementation shortfall is largely focussed, is the market impact of the trading related to a transition. This can be thought of as the forces put in motion by the trading that widen the gap between the legacy sales and target purchases,” he says.

The second is opportunity cost: distinct from the market impact of trading, which relates to forces moving the market outside the transition activity. Accurate reporting of these helps to guide expectation and set the trading approach recommended by managers.

The apparent free cost of trading at or around the close (target MOC) is important as it can be sold as a transition solution which on paper makes Implementation Shortfall look expensive. When transitioning assets at a single point in time where the benchmark and the execution are the same, transitions appear free of risk and implied cost, but clients should be wary of free lunches. Closing auctions are a complex array of supply and demand forces which provide invaluable liquidity, but also volatility and uncertainly. Transitioning to target MOC is not Implementation Shortfall for the simple reason that one considers cost and the other performance.

The invisible cost impact on a transition by trading at the benchmark market close is particularly problematic given that implementation shortfall can still be misunderstood by some clients. Webster says that a popular error is to compare the cost of the legacy portfolio with that of the target portfolio at the end of the transition, a blunt measure which fails to account for the precise moment during the transition that legacy assets were sold and target assets bought.

Execution algorithms and transaction cost analysis

The tools employed to evaluate the impact of trading the close are among a wider technological arsenal with which transition managers seek to distinguish themselves.

Pre-trade, the clearer the picture the transition managers and client have regarding the volume of the stocks, the better placed they are to select the right date and time to start trading. It also makes for better communication about where the costs are likely to come from and how they can be minimised – comparing the contribution from technology stocks as against banking stocks, for example.

James Woodward, head of portfolio solutions, Asia Pacific at State Street in Sydney says a new battle front is chat rooms and Reddit threads: through one of the company’s alternative data partners, clients are able to scrape thousands of digital media sources to measure the sentiment and intensity of media coverage associated with various assets.

Post-trade, the suite of solutions provided under the broad heading of transaction cost analysis has become an essential resource for clients, too.

“Tools should allow clients to look into every facet of the transition, drilling down to see exactly how much one stock was responsible for performance,” says Woodward. Monitoring prices minutes then seconds ahead of the close, and comparing those with the next day’s opening prices, give a precise picture of the likely impact. Parent and child orders within individual stocks can be compared against various metrics.

“This type of deep dive helps us explain exactly what we did and what the impact was. The measures are allowing clients to investigate what was traded, where slippage occurred and why, how performance compared with benchmarks, what contribution different algorithms made to the outcome, including what signals to the market they generate while the trades occurred,” says Woodward.

Waverton Investment Management, equity fund merger

Completing in November, Waverton Investment Management successfully implemented a global equity transition in two funds ahead of a merger. The transition consisted of collective funds, equities and FX which needed to be reconciled, traded and settled inside the one-week ‘black-out’ period. In advance of the event, Goldman Sachs’ transition team worked collaboratively with Waverton, which handled the event internally, providing assistance and expertise to deliver the most effective implementation route to minimise turnover across the two funds. It helped explore different trading strategies, as well as event-specific and operational aspects.

The transition was implemented with the help of Goldman’s proprietary Algorithmic Portfolio Execution (APEX) suite to establish the optimal trading schedule and mitigate market risk. APEX enabled a detailed execution schedule, which was valuable for projecting the end-of-day portfolio composition in the context of a multi-day trade and ensuring that each fund could continue to satisfy their concentration limits during the transition period.

It was successfully implemented, minimising implementation shortfall, whilst respecting beta neutrality and cash management constraints across regions. Realised transaction costs were in-line with the pre- trade cost estimates for each fund, and were communicated ahead of time to the stakeholders.

“It has been a real team effort and being able to work with the Goldman Sachs transition management team and leverage their experience in this type of transaction has been invaluable”, said Louissa Oakes, head of trading at Waverton Investment Management.

This article is part of the Transitional Management Guide 2022, and if you want to download the full guide click here.