Minimizing Execution Costs 97 generate more business for them. They may also have a better understanding of market trends, and trade on volume generating more business for brokers, giving them more bargaining power to find the best execution price. 9.4 Cost of Waiting Large block trades affect bid-ask spread and have consequences with price impacts. However, there is a cost of waiting, which prevents large investors from breaking up trades into small lots or buying and selling large quantities without affecting the price or spread significantly. The penalties relating to the cost of waiting occur when investors wait to buy, but at a higher price, reducing expected profits from the investment; or when the price, of the asset rises significantly to the point that the asset becomes overvalued. The factors determining the cost of waiting include the following:3

. Whether or not the valuation assessment is based upon private information or is based on public information. Private information tends to have a short shelf life in financial markets, and the risks of sitting on private information are much greater than the risks of waiting when the valuation assessment is based upon public information. The cost of waiting is much larger when the strategy is to buy on rumors of a possible takeover than it would be in a strategy of buying low PE ratio stocks. . Whether or not other investors are actively seeking the same information in the market. When an investor possesses valuable information, the risk of waiting is much greater in markets where other investors are actively searching the same information.

. Whether or not the investment strategy is shortor long-term. Shortterm strategies are much more likely to be affected by the cost of waiting than longer-term strategies. This can be attributed to the fact that short-term strategies are more likely to be motivated by private information, whereas long-term strategies are more likely to be motivated by views on value. . Whether or not the investment strategy is a contrarian or momentum strategy. In a contrarian strategy, investors are investing against the prevailing tide; the cost of waiting is likely to be smaller because of this behavior. The cost of waiting in a momentum strategy is likely to be higher since the investor is buying when other investors are selling 3 Aswath Damodaran, Trading Cost and Taxes, pp. 1720, (cid:2)adamodar/pdfiles/invphiloh/tradingcosts.pdf.

98 Electronic and Algorithmic Trading Technology and vice versa. Traders with superior information earn abnormal returns that just offset their opportunity and implementation costs. This implies that the portfolio return should on average offset the fees and trading costs imposed by the investment manager. 9.5 Explicit CostsCommissions, Fees, and Taxes Commissions, fees, and taxes are unavoidable costs and can significantly alter a fund or stocks portfolio. Taxes are important because some investment strategies expose investors to a much greater tax liability than other strategies (see Exhibit 9.5). A fund with a long-term horizon philosophy may have lower transaction costs as well as lower tax implications. Funds that trade frequently may be affected by higher taxes. An accurate measure of an investment strategy is observing after-tax returns and not pre-tax returns. 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Large Value Large Blend Large Growth