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From concept to practice.
(ProQuest Information and Learning: ... denotes formulae omitted.)
Implementation shortfall has become the industry standard for evaluation of portfolio transitions. Perold [1988] introduced the notion, which he defines as the difference between the calculated performance of a paper portfolio and the actual performance of an identical real portfolio based on actual market transactions. Perold's key innovation was to extend the traditional perception of transaction costs to incorporate the opportunity cost of delaying the sale of a security intended for disposition or the purchase of a security targeted for acquisition.
We present a comprehensive empirical analysis of implementation shortfall using a unique sample of individual security transactions. The sample includes detailed information for more than 800,000 transactions, including information about how the trades were implemented. Beyond the empirical analysis, we introduce an adjustment to implementation shortfall to account for liquidity and risk, based on a smaller sample of transition-level data. We argue that without adjustment it is impossible to compare the quality of portfolio transitions.
DATA AND METHODOLOGY
Institutional investors reallocate portfolios periodically to shift their asset mix, reshuffle investment managers, deploy new cash flows, or disburse funds. They face a variety of costs when they undertake these transitions, including commissions, bid-ask spreads, market impact, opportunity cost, taxes, and foreign exchange costs. Market impact and opportunity cost account for most of the cost. Market impact refers to the adverse price movement that occurs in response to the purchase and sale of securities, while opportunity cost refers to price movements arising from exogenous forces.
In an effort to contain these costs, many institutional investors retain transition managers to implement reallocations. Transition managers implement portfolio transitions cost-effectively because they cross many trades internally rather than trade the securities in the open market, thereby avoiding commissions and bid-ask spreads and reducing market impact and opportunity cost.
We analyze 1,541 equity transitions performed by the world's leading transition manager during the period from January 2004 through January 2006. The sample includes 877,657 buy and sell transactions covering 10,070 securities in 10 sectors and 64 countries. The total value traded exceeds $300 billion.
For each of these transitions we begin by recording the prices of the securities to be bought and sold as of the inception...