The Incredible Story of
Transaction Cost Management:
A Personal Recollection
WAYNE H. WAGNER
I
WAYNE H. WAGNER t’s 1984. The summer Olympics are in
is a founder of Plexus Los Angeles, the winter Olympics in
vi
Group, Inc., in Venice,
Sarajevo. Wayne Gretzky Is in his prime
CA.
waynewagner@stanfordalumni.org as the Oilers win the Stanley Cup; the
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Celtics and the Lakers stand out in the NBA
finals. Roger Clemens is a rookie. The best
news from 1984 is what didn’t happen: 1984
doesn’t look anywhere near as grim George
or
Orwell’s apocalyptic vision.
Personally, I am very busy this day,
April 24, in 1984.1 Wilshire Asset Man-
F
agement is putting into place a $1.3 billion
Wilshire 5000 Index Fund for the Min-
ft
nesota State Board of Investment. We had
convinced the SBI that indexing could com-
a
pete with active management performance,
Dr
that indexing technology had progressed to
the point where it was feasible to mirror the
Wilshire 5000 Index in a real portfolio, and
that Wilshire could do it best due to exten-
or
sive work in indexing. We had tutored 40
organizations in running index funds with
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our software, but we had never actually run
any portfolio ourselves.
We were anxious to demonstrate our
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proficiency to the SBI. One of our best cards
is to show innovative trading savvy to keep
trading costs low. We devise several trading
techniques to disguise our footprints and
reduce impact, but those techniques are not
the subject here. This narrative is about how
the hidden costs of trading were discovered.
SUMMER 2008
IIJ-JOT-WAGNER.indd 1
ly
On
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We are building a 2,300-stock portfolio
including a very large number of industry
representatives to create a well tracking port-
folio without holding all 5,000-plus securities
in the index. I’m sitting on the trading desk,
phoning the brokers with lists of company
names which we’re trading. (Remember, it’s
1984; the FAX machine is high-tech.)
I come across a company, quite famous
at the time, even to me, named Green Tree
Acceptance. The company financed manu-
factured housing, later called mobile homes,
but then known as “trailers.” Clearly, who-
ever was in charge of assigning industry codes
didn’t know that, for he had classified Green
Tree as a Forestry company. (Green Tree =
Forestry; makes sense, right?)
I am dumbstruck. Not by the fact that
Green Tree was misclassified, but by the fact
that it didn’t matter that I knew nothing—
absolutely nothing—about the thousands of
companies I was buying. Not only that, I was
buying on the basis of erroneous information!
How can it be that demonstrable dummies,
such as me, can sell index funds on the basis
of highly competitive performance?
I knew from previous measurement
at Wells Fargo and Wilshire that almost all
analyses of quantitative selection models or
financial analysts’ picks showed value in the
decisions, usually in the range of 50bp. Okay,
so analysts’ models add 50bp, but performance
records show portfolio managers underperform
THE JOURNAL OF T RADING 1
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 by something like 50bp before fees. Could the leakage
be transaction costs? Not by the then-current estimates
of impact plus commission costs, which were in the
range of 25bp. If the value added by investment selection
is 50bp and implementation costs take away 25bp, the
net value-added should be positive, right? But it wasn’t.
(And still isn’t!) Where did the value go?
Well, that wasn’t my biggest problem at the time,
so I set it aside for many years. Although I thought about
it occasionally, it wasn’t until the late 1980s that I got
serious about this conundrum.
THE INCREDIBLE DISAPPEARING
ACT OF HAROLD DEMSETZ
Before going forward, let’s trace back a little bit
further. How many readers are familiar with the name
Harold Demsetz? When I asked that question to my
Montréal audience, I wasn’t surprised to receive blank
looks. (Harold wouldn’t be surprised either!)
Harold might not be renowned as the father of Best
Re broker behavior. To me, there seemed to be much more
Execution as a discipline rather than a legal concept, but
he was first to measure it. The quiet birth of what we now
or
know as Transaction Cost Measurement started in 1968
with an article by Harold Demsetz.2 Considering the
paucity of available data and the general lack of interest
F
in the topic, Harold’s work was very illuminating.
I have a personal story concerning Harold. My
ft
wife and I were attending a cocktail party in the early
1990s at the home of a UCLA professor. I walked up
a
and introduced myself to a stranger—and it’s Harold
Dr
Demsetz! I enthused about this seminal work which
had so strongly inf luenced my career. With a wry look
on his face, he said, “As far as I know, you’re the only
person who ever read it.”
or
SOME MORE ANCIENT HISTORY
th
Let’s move on to 1972, to the fabled Management
Sciences Department of Wells Fargo Bank. An investor
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with a background from The University of Chicago,
the hotbed of early quantitative work in finance, was
searching for someone who could create a real-world
application of the then newly minted Sharpe model. Of
course, we now know this as an index fund, although
the term wasn’t invented until later. This first attempt
was crude and largely off-base, but workable, except
for one thing: We couldn’t afford to pay the normal
2 THE INCREDIBLE STORY OF T RANSACTION COST M ANAGEMENT: A P ERSONAL R ECOLLECTION
IIJ-JOT-WAGNER.indd 2
transaction costs associated with brokers protecting
themselves against knowledgeable traders. (Which, as
demonstrated above, we clearly weren’t.) In a world
of fixed commissions and only active managers, how
could we get around the problem of incurring active
trading costs in a heretofore inconceivable non-active
portfolio?
ly
We devised some passive trading techniques that
we called teddy-bear trading to turn our indifference to
On
individual stocks selections into an advantage. We wrote
this up in 1975 for the Financial Analysts Journal, which I
believe was the second article on transaction costs pub-
lished.3 We went on to other things, while progress was
ew
made elsewhere.
In the late 1980s, commercial transaction cost
measurement services were offered by Gil Beebower at
A.G. Becker and Abel Noser. I knew them as friends,
vi
but to me the services seemed to be missing something.
The objective seemed to be to cast a suspicious eye on
to understand: What role did the trader himself play in
the process? How about the portfolio manager?
Around 1990, Plexus Group was in need of new
product, and our attention turned again to the still lightly
plowed fields of transaction cost measurement. It seemed
that there was more that could be done to help invest-
ment managers reduce transaction costs. In all truth, this
was an uphill fight, as suggested by the Demsetz quote.
Portfolio mangers, chief investment officers, and head
traders all echoed the thought best expressed to me by a
Canadian investment manager: “I pick stocks. The rest
is just plumbing.”
Later, I would add: “leaky plumbing.” For a while
I was infatuated about quotes on plumbing. Here is the
best, from the eminently quotable John Gardner:
We must learn to honor excellence in every
socially accepted human activity, however humble
the activity, and to scorn shoddiness, however
exalted the activity. An excellent plumber is
infinitely more admirable than an incompetent
philosopher. The society that scorns excellence in
plumbing because plumbing is a humble activity
and tolerates shoddiness in philosophy because
it is an exalted activity will have neither good
plumbing nor good philosophy. Neither its pipes
nor its theories will hold water.
SUMMER 2008
5/20/08 5:22:30 PM
 Now we’ve come full circle to the basic conun-
drum: can costs explain the difference between port-
folio managers’ positive potential value and the negative
realization? Three events added momentum to our new
pursuit:
• A new model: In 1988, Andre Perold defined imple-
mentation shortfall as the true all-in cost of trans-
acting, calling on Treynor’s thoughts of 20 years
before.
• A new data source: Seth Merrin’s first functional, and
soon to be indispensable, Order Management System.
For the first time, data was available to trace the
fundamental questions: who did what, when, why,
and how?
• An urgent motivation: Plexus Group’s relationship
with Instinet’s Crossing Network had come to
a close. We needed a new product to generate
revenue!
Fortunately we had good friends in the industry
who showed interest in anything that would help
them improve performance. I am forever indebted to
or
Ted Aronson of (then) Aronson and Fogler, and Mark
Edwards, who was running active quantitative portfolios
for Minnesota SBI and ultimately became an inspiring
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partner at Plexus. Importantly, no one had ever looked at
this level of transaction data: the order from the portfolio
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manager, and the process by which it transformed into
changes in portfolio holdings.
a
We had the total cost from Perold’s insight. We
Dr
could isolate the commissions and impact, and they
were in line with expectations. But there was something
more, a missing piece: the Perold cost was three times
as large as commissions plus impact. It didn’t take much
or
searching of the data to discover where the hidden costs
were, and to identify two sources of the problem.
th
First, traders were focused on monitoring their
potentially disloyal friends, the brokers, and on min-
imizing the impact of their trading on the market.
Au
Meanwhile, in front of their noses—but completely
invisible—were other, insidious, egregious, hidden costs
of trading:
• The traders focused on minimizing impact, but
that was only part of the story.
• If you fail to trade while the stock is trending, you
will ultimately trade at worse prices. The “random
SUMMER 2008
IIJ-JOT-WAGNER.indd 3
walk” theory of price movements didn’t apply when
there was latent, unfilled demand (or supply). Until
that committed but uncompleted trading interest
was filled, there would be constant one-sided pres-
sure on the stock price. The result: delay hurt much
more often than it helped.
• This effect can be measured by simple arithmetic,
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when you know the manager’s intentions. Many
terms have been applied to this cost, but we called
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it “delay” cost or “opportunity” cost. It is almost
koan-like: the cost of not trading.
• By measurement then, and even now, these egre-
gious costs comprise 60-75% of the total costs. Yet
ew
nobody, myself included, even suspected them,
although it seems so obvious now.
Secondl, broker misbehavior might have been a
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problem, but it wasn’t the problem. The problem was
one of institutional trading size compared with trader
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motivation, combined with a whole lot of temporizing,
hedging, and second guessing of the trading decisions.
The traders’ self-standard of excellence—minimizing
impact—was disconnected from the primary motive:
the maximization of investor wealth.
It turned out the traders were right when they
complained that the trade cost analyses of the day were
simplistic and naïve. The data showed many levels of
complexity, the “complex tapestry” of skills, handoffs,
and tradeoffs as described in the CFA-Institute’s Best
Execution Taskforce Report:
• Managers would slowly feed orders to the desk,
imposing ever-shifting price limits and quantities;
• The size of the institutional orders often exceeded
the practical limits of available liquidity;
• There was little attempt to prioritize orders, so
traders could not tell which orders were the most
sensitive;
• Traders would attempt to time the market, usually
unsuccessfully, holding back when they didn’t like
the tenor of the market.
All these factors contributed to the invisible costs,
which were two to three times the explicit costs. Invis-
ible, yes, but also egregious: if the price eroded in a stock
to be sold because of manager hesitancy, trader reluc-
tance, or market conditions, real losses were incurred by
the investor, both on sales and purchases.
THE JOURNAL OF T RADING 3
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 What a thrill! We were standing on the edge of
knowledge, observing from a completely new perspective,
seeing what no one had seen. Clearly, there was a busi-
ness proposition here—an opportunity to enhance returns
by tightening up the plumbing. All Plexus needed were
customers.
No matter how striking our findings were to me, it
often failed to evoke a similar response in the plumbing-
haters we hoped would become customers. Not only
did we need to convince them that we had found a
better way, we had to persuade them that their previous
knowledge—and by a quick mental deduction, their
skills—were incomplete and obsolete.
I have a Dilbert cartoon in my scrapbook where
Dogbert describes himself in the first frame as “the quan-
tifier of unquantifiable things.” In the second frame, he
says, “I declare you to be worth $85.” In the third frame
you see Dogbert walking out of the office followed by
a scream of epithets. Dogbert shrugs: “No one likes to
be quantified.” That is a fairly accurate description of
our early commercial encounters. Still, eventually the
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value proposition prevailed.
or
TODAY: WHERE ARE WE NOW?
I’d like to share with you my observations from
F
40-plus, on-and-off years of observing markets, trans-
acting, and transaction cost management (TCM).
ft
TCM today has deep penetration into the practice
of investment management and trading. In fact, we’re at
a
a level of understanding and applicability inconceivable
Dr
just a few years ago.
1. The hidden costs are the major costs, totaling
two-thirds to three-quarters of the total cost of
or
implementing institutional investment decisions.
The source of hidden cost is the inability to create
th
liquidity upon command, i.e., when it is needed
the most. The iceberg is the key insight to the pro-
cess. Trading cost, we now know, is certainly not
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the commission and not just impact. It is the slip-
page between the costless value of the investment
idea and the performance realization. Perold’s idea
reigns supreme.
2. TCM is most effective as a feedback and self-
evaluation process. It is an exercise in effective
business management under conditions of uncer-
tainty. The key insight is that it is a process, and
4 THE INCREDIBLE STORY OF T RANSACTION COST M ANAGEMENT: A P ERSONAL R ECOLLECTION
IIJ-JOT-WAGNER.indd 4
not an outcome. As trade directives move down
the chain of knowledge, valuable feedback infor-
mation now moves in the opposite direction and
alters future behavior.
3. We have learned the importance of data. Long
ago, Pythagoras said: “Without proof there is
only the poverty of arguable opinion.” Similarly,
ly
without data—accurate, timely, and highly speci-
fied data—all we can practice is conjecture and
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self-justification. Yet the data we capture today is
increasingly inadequate to the vastly more com-
plicated task of evaluating complex, conditional,
and rapidly changing algorithmic trading and dark
ew
pool searches.
4. Structural impediments to buyer meeting seller
with multiple middlemen inf lated costs by at least
a factor of two. Many of those middlemen could
vi
be found on the f loor of the exchanges, where
we could see the energy of financial markets per-
sonified. Nostalgic, picturesque—and expensive.
Very expensive as it turns out, and in ways no one
suspected. This is one occasion where regulation
clearly worked to the benefit of investors: the SEC
and other regulatory bodies were right to force
down the commission and the spread. Squeezing
out the middlemen’s “vigorish” sparked the move
to electronic trading venues, which can do the job
a million times faster, with lower error rates and
much less information leakage.
At the height of the internet/biotech frenzy in
2001, Plexus Group recorded one-way costs at 142bp
for USD large capitalization stocks. By 2005, these costs
dropped a remarkable 64%, to 51 basis points. They have
stayed in that neighborhood ever since.
5. Lower transaction costs empower lower threshold
strategies. Many good ideas that would not be
profitable in a high-cost environment can now be
executed. Many a worthless old slag heap can now
be re-mined for gold worth $1,000 an ounce.
6. There are three big cost factors that determine
what a trade is going to cost: the size of the trade
relative to the trading volume; the small capitaliza-
tion or thin trading supply of the company; and
price momentum due to a conf luence of trading
interest on one side.
SUMMER 2008
5/20/08 5:22:30 PM
 7. How do we think about the determinants of
transaction costs? Here’s my take on the market
dynamics that determine the outer bounds of
transaction costs:
a. The minimum cost is the structural cost of pro-
ducing the trading service. In a minimal cost
market, the lowest cost producer becomes the
dominant player.
b. The maximum cost is expectational, and lies in
the realm of the portfolio manager, who views
the trade in terms of what can be gained for
his portfolio: how much am I willing to pay to
capture the potential of this investment idea?
c. Liquidity failure occurs when the other side of
the market disappears, often in a f lash. Once
frightened, liquidity can stay away for a long
time; consider the sub-prime meltdown or the
Russian bond crisis for LTCM. Keynes said this
best: “The market can stay irrational longer than
you can stay solvent.”
HOW DOES THIS AFFECT INVESTORS
or
AND FIDUCIARIES?
If we add together the components of cost for an
F
average U.S. mutual fund, we typically come up with
numbers like this:
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Management fee 75bp
a
Administration expenses 20bp
12(b)–1 fees 50bp
Dr
Total fees and expenses 145bp
At the height of the Internet frenzy, we measured
or
transaction costs peaking at 142bp each way for buying
and selling. Coupled with a 100% turnover rate, trans-
action costs could be twice the total fees and expenses
th
shown above. Even in today’s more efficiently operated
markets, transaction costs can still be the largest draw-
down of investable funds. So, as a fiduciary, charged
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with acting in the best interests of the fund holders,
where would place your emphasis?
I suggest that the interests of the beneficial owners
are best served by following the following logic: 1) Effec-
tive oversight means knowing what to look for; which
questions to ask. 2) All costs are negative performance,
therefore anything that reduces costs without harming
SUMMER 2008
IIJ-JOT-WAGNER.indd 5
performance potential is beneficial. 3) Consider Jack
Bogle’s suggestion that the easiest way to be in the first
quartile of performance is to be in the fourth quartile of
costs. 4) Look for the low-hanging fruit to reduce the
drag of transaction costs.
Am I suggesting that fiduciaries should become TCA
experts? Empathetically, no. But the people to whom you
ly
delegate your fiduciary responsibility should be.
On
WHAT WE STILL DON’T KNOW
TCA has come a long way, but some important oppor-
tunities remain. I can think of several key issues that will
ew
confront transaction cost researchers in the future.
1. Most of the costs occur according to a sort of 80:20
rule: 20% of the trades create 80% of the costs. It
vi
seems to me, however, that it is probably not pos-
sible to avoid the runaway trading situations and to
Re fill our trades before the price shoots up (or down).
Here are my thoughts on the matter: Except for
f low trading, the reason a manager decides to trade
is because something has changed—i.e., a signal
that calls out a response. It could be news, earnings
surprise. relative change in value, changing of a
rating, data errors in a quantitative database, etc.,
etc. But if nothing changes, the portfolio manager
sees no motivation to trade.
OK, but our heroic portfolio manager isn’t the only
signal reader in the market; others will react as
well, and the result is a herd effect. Thus the price
shoots up because we, the collective, the herd, “we”
are suddenly anxious to trade.
As long as there are surprises in the market, there
will be runaway trading cost situations. The silly
solution to this problem would be to trade when
there’s no immediate reason to trade, but would
you invest with a portfolio manager who trades for
no reason?
2. The same problem comes up when it’s time to focus
our attention on the TCA reports. Our attention
is naturally drawn to the blowups, but the trade
desk alone cannot contain the damage. True cost
containment comes from dealing with the run-of-
the-mill trading situations, not the conf lagrations.
As with fighting brush fires, containment comes
in fighting the many sparks before they blow up.
Once the fire is out of control, the damage cannot
THE JOURNAL OF T RADING 5
5/20/08 5:22:30 PM
 be contained. As we experience in California, all
wildfires extinguish when they reach the ocean.
So it is with trading situations; thus the disasters du
jour will probably always be there. The trade desk
can make heroic efforts to mitigate the damages,
but the winds blow too strong.
I can see two possibilities for mitigating the damage,
one before the fact and one after. Both rest in the
domain of the portfolio manager, not the trade
desk. Before the fact, the solution is to consider the
risk. As we’ve recently found out, quantitative tech-
niques such as VAR (value at risk) all too often dras-
tically understate the risk. Gaussian statistics don’t
work during a regime change: they can’t predict 10
sigma changes. Perhaps the best solution is to induce
terrible nightmares for the portfolio manager and
motivate him or her to clear-cut the potential fuel
that could lead to a wildfire disaster.
The after-the-fact solution is to refuse to join the
herd: wait six weeks and then decide if you still
want to own the stock. This tactic doesn’t avoid the
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loss, it absorbs the blow, then looks to a new day
when the value of the company can be reassessed
or
in a more balanced frame of mind.
3. Another problem is our obsession foreseeing the
future through transaction cost predictors. Over
F
any time frame greater than a few seconds, this
may be the impossible dream. Predicting all-in
ft
costs is the same as predicting future prices. If there
is such a person who can do that, he has a great
a
career ahead of him in a hedge fund. Or a religious
Dr
movement.
The truth is that the explanatory power of a pre-
dictor over the full execution of an institutional order
or
is very, very low. The same equations that can explain
costs after-the-fact lose over 90% of their power when
th
applied to predictions. It is impossible to forecast inde-
pendently occurring demand and supply in an unstable
situation. Excessive reliance on predictions is like betting
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on a coin f lip.
THE BOTTOM LINE
Finally, the most important point: How have
reductions in transaction costs affected bottom-line
investment performance? I have some perplexing news
6 THE INCREDIBLE STORY OF T RANSACTION COST M ANAGEMENT: A P ERSONAL R ECOLLECTION
IIJ-JOT-WAGNER.indd 6
here: I cannot document that gains in trading efficiency
result in thrillingly better portfolio returns.
We have two data sources we can look at: the Stan-
dard & Poor’s SPIVA (S&P50 Index vs. Active) data, and
the ITG/Plexus Group client database.
The SPIVA data shows no trend: I divided the eight
years of available data in half. In the first four years, from
ly
2000 to 2003, the S&P500 index outperformed 54% of
large-cap mutual funds. For the 2004-2007 period, the
On
index outperformed 63% of the managers. Certainly no
indication of improvement there.
The Plexus data is more encouraging. In 2002
the average costs were 140bp, the costless returns were
ew
110bp, and the net value added was a negative 30 basis
points. By 2007, average costs were down to 40bp,
which matched the costless return of 40bp, with a net
value added of zero.
vi
Zero value added? Isn’t that wonderful? I would
describe myself as unenthralled, but unappalled.
The cheeriest conclusion I can reach is that this
indicates market efficiency, in the “no free lunch” sense.
Perhaps the best that can be expected in a hotly com-
petitive market for investment ideas is that the search
costs will be covered on average. This conclusion would
fit nicely into a robust definition of market efficiency,
incorporating the wedge costs of search and transaction
costs.
Some darker possibilities include:
• Could it be a curse of optimism, that managers
will adjust their idea production to the hurdle
rate and will always overstate their information
advantage?
• Perhaps we suffer recently from a lack of oppor-
tunity—i.e., fewer stocks with skyrocketing pros-
pects in recent years.
• Is someone else, such as the hedge funds, capturing
the advantage?
• Or perhaps there’s just too much noise in perfor-
mance data and too loose a connection to transac-
tion costs to notice the effect.
Nonetheless, we have made great progress, and it
is worthwhile to conclude with a brief list of some of
the major accomplishments.
SUMMER 2008
5/20/08 5:22:30 PM
 1. We have made great progress in understanding
market microstructure, and how this affects the
cost of trading.
2. The science of trade cost measurement has become
widely accepted, and has led to significant enhance-
ments to the way we trade securities.
3. These new trading methods represent a challenge
ENDNOTES
This lightly overblown title comes from the kindly and
fertile imagination of my friend, Robert Pouliot of RCP
Partners, S.A, who invited me to give a keynote speech to
the Centre for Fiduciary Excellence in Montreal, Quebec on
March 12, 2008.

to the TCM process. How do we gather the data
to make intelligible choices among algorithms and
ly
1
I ask your forbearance for all the vertical pronouns in
this exposition. The first-person voice communicates as more
evenly balanced in a speech than it does in writing.

the operative settings that govern them?
4. The TCM revolution has won major victories, but
is still being fought daily. Continuing evolution
will call forth new insights and new challenges.
On
2
Demsetz, Harold, “The Cost of Transaction,” Quar-
terly Journal of Economics [February, 1968].
3
Cuneo, Lawrence, and Wayne H. Wagner, “The Costs
of Transacting.” Financial Analysts Journal [November/December

ew
5. Fiduciaries are well served by the attention they 1975].
pay to these costs, not only for gains in efficiency,
but also for the deeper understanding of the invest-
ment process it provides. To order reprints of this article, please contact Dewey Palmieri

vi
at dpalmieri@ iijournals.com or 212-224-3675
6. Despite whatever successes we’ve had in the past,
best execution is particularly important now, when
the patterns and practices are undergoing con-
tinuing rapid evolution.
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Yes, there’s much to be done, and yet we’ve come
or

a long way and that is cause to celebrate. We have saved

billions of dollars for investors, and I am grateful to have
an opportunity to make my own contribution to this
F

noble cause.
a ft
Dr
or
th
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