Another consultant doesn't seem to think much of VWAP strategies at all.
Article: Volume Weighted Average Price, Evaluation or Evasion?
Plexus Group, 1999
Traders in London refer to VWAP trading as "heading for the air-raid shelter." Rather than trading to maximize performance, traders head for the shelter of a more pliant benchmark. In the process, the investment objective can become secondary to merely looking good against VWAP. The key to effective implementation is to overcome conflicting objectives and align trading strategy with investment strategy.1
What is VWAP?
The Volume Weighted Average Price, commonly called VWAP, is probably the most familiar trade evaluation benchmark, at least to the pension plan sponsor community. The computation of a daily VWAP is straightforward for anyone with access to records of daily stock transactions. Simply add up the dollars traded for every transaction (price times shares traded) and then divide by the total shares traded for the day.
The use of VWAP to judge trading is simplicity itself: if the price of a buy trade is lower than the VWAP, it is a good trade; if the price is higher, it is a bad trade. For a sell trade, the valuation reverses. Individual trade measurements can be gathered by trader, broker or manager to judge quality of execution.
In this commentary we show how VWAP relates to price formation in today’s markets. We then show that under certain common conditions VWAP evaluation may be misleading and even harmful to portfolio performance.
Is a Lower Price Always Better?
How would you evaluate the cost of buying a house? Adding up the Realtor’s fee, mortgage points, legal and loan documents and other ancillary costs wouldn’t evaluate whether the price you paid was attractive.
If all the houses in a suburb were alike, a record of sales prices could show whether your price was low compared to the prices paid for similar houses. Even if the houses are identical, the buyers might not be. One young family may have just moved from Iowa and wants to settle in before school starts. Another might be more sensitive to loan terms than price. A third may be attracted to a premium neighborhood and be willing to pay up for the privilege of living there. Someone else could be aware of pending highway improvements, and want to buy before everyone knows. A speculator might know the builder was in financial straits, and seek to buy all unsold houses. The builder himself might believe interest rates are coming down and be less willing to deal.
The lowest price may not be the most satisfying price for these other-motivated buyers. While their price might be higher, we can’t categorize them as rubes without knowing their motivation and what constitutes a good deal to them. Motivation and circumstance can also effect how attractive a price is to an equity trader.
Negotiation Skills
Strictly comparable housing price data is difficult to find, but each stock market trade is public record. VWAP uses this comparative data to distinguish good negotiators from rubes. Even though it appears that everyone buys the same entity, it may not be that simple.
At least two skills go into every trading tactic: negotiation and timing. Consider negotiation first: a better negotiator, it would seem, cajoles the other into a less favorable price.
A market maker "makes a market" by assuring that, at all times, a quote to buy (the bid) or sell (the offer) is displayed to the market. If there is no quote from the public, the specialist posts his own. Market buy orders execute at the offer price: sell orders execute at the bid price. The buyer or seller steps across the gap to complete a trade. Both receive the market quote, and both trade at the best price available for immediate liquidity.2
A buyer or seller makes the other party step across the gap by using a limit order. A limit order states the maximum price a buyer is willing to pay, or the minimum acceptable selling price. A trade occurs when the other party crosses the gap.
This technique introduces the timing dimension and the critically important tradeoff between immediacy and price. A market order trades immediately but crosses the gap; a limit order will fetch a better price, but only when someone else finds that price acceptable.
In fact, more than timing is surrendered: the trader loses control of whether the trade will execute. There is no guarantee that a limit order will ever trade. Thus limit orders balance gains from a better price against uncertainty of when and if the trade will complete. In other words, the opposing trader receives an option that will be exercised only when that option has value.
Option value occurs when the other side’s information makes the limit/option price attractive. For example, a limit order to buy a $20 stock at $19.75 could execute quickly if bad news arrives. The uncomplimentary term applied to a trader whose limit order is lifted by a wilier trader is "picked off." Thus limit orders may result in unfavorable outcomes exercised at the option of the opposing trader.
Timing the Trades
Timing, of course, is a valuable skill. There are legions of action traders who have (or think they have) timing skills. Market makers, hedge fund operators, day traders, scalpers and others actively trade the market by applying timing skills. There is a crucial difference, however, between successful trading and successful investing. Action players neither know nor care about the company being traded. What’s important is the action, the effect rather than the cause. Action traders go to where the action is.
Investor traders lack that flexibility. Since their job represents the final task in a sequential decision process, they are expected to trade specific stocks expeditiously. Trade information cannot remain proprietary for long; trade delays result in trade prices that can differ greatly from the manager’s original decision price.
The trader’s task is to please the managers who determine which stocks to buy or sell and when prices are attractive. The manager’s selection and timing decisions are integral to the trader’s assignment.
Indeed, the choice between market and limit orders illustrates the tradeoff faced by every trader: is it better to accept the market price now and complete the trade, thus completing the decision process? Or is it better to wait and hope for an opportunity to trade at a better price?
Trading the Whoppers
Repeated Plexus Group studies of institutional trading find that most institutional trading occurs in filling orders that exceed one day’s volume. When large numbers of shares must be traded, liquidity concerns compete in importance with price goals. Trade evaluation becomes much more complicated.
Larger trades are usually important trades on which managers stake future performance and reputation. Action traders watch the market for these and try to profit by piggyback on those trades. A naïve trader could indiscreetly telegraph interest to the market. Action traders can then "cut themselves in" by soaking up available liquidity and reselling to the unskilled trader.
Conversely, a skilled trader is keenly aware of the need to disguise the trading to prevent leakage to action traders. By dealing in amounts below or beyond the radar screen of the action trader, using trustworthy agents and large principal trades, the skilled trader fills the large orders while keeping costs to a minimum.
Note however that the cost may not be attractive relative to VWAP. This reveals a shortcoming of VWAP: it pays no attention to the size of the trade, although it is intuitively obvious that size is an important factor in the cost of trading.
VWAP judges a trade solely by relative rank. In a VWAP frame of reference, there is no way to address the question "What should this trade cost?" Knowing the cost of trading in size is valuable to traders and manages alike, who must decide for each buy and sell whether the idea is valuable enough to cover the expected in-and-out trading costs.
Capturing the Research Advantage
Institutional traders execute manager decisions. As with the house-price analogy, we must look deeper into trading motivation to determine whether a particular price represents a good or bad execution.
The simplest motivational difference is the familiar one between value and growth managers. Value managers look for underpriced situations, where they can buy stock at a bargain price. The lower the price, the more attractive. In contrast, growth managers react to good news that hopefully portends more good news. Cheapness doesn’t rank highly in the decision process; completion of trades carries far more weight. To summarize, growth managers buy on good news while value managers sell stocks on good news. Thus value and growth managers frequently trade against each other.
Growth/news oriented managers are at a distinct trading disadvantage because they buy at times when buying interest dominates the market. They are more willing, indeed compelled, to step across the gap.
Thus growth traders are frequently disadvantaged in a VWAP evaluation, while value traders tend to rank highly. This has less to do with skill, more to do with triggering motivation. Indeed, growth traders often develop higher skills forged by frequent trading in hotly competitive situations.3
Remember, the trader’s objective is to capture the value of the research. When common insights are shared by competing investment managers, the best traders realize they must move fast to capture liquidity early on. VWAP may judge these trades as poor, yet traders often identify these high-skill trades as among their very best. The worst traders in fast moving markets are those who hang back while the market moves away, leading to delay costs. The manager may even cancel the order if the price moves out of range, thus removing the (non) trade from VWAP evaluation. Yet a canceled trade is often the very worst trade in that it wastes the insight of the analyst and manager. By ignoring canceled trades, VWAP evaluation may judge traders who duck difficult trading situations to be among the best.
Of course, the division of all trading into value and growth motivation over-reaches. Much trading, such as balancing or inflow trading, is low motivation. These decisions are not price sensitive and evaluation by VWAP analysis will not mislead.
Motivated trading cannot be correctly judged by comparison to prices that reflect other objectives. What matters at the end of the day is who brought home the bacon; who was most effective in capturing research insights. A trade between a value manager whose stock has reached the price target and a growth manager trading on an astute recommendation may both secure an excellent trade in the context of their decision process. The best traders understand the motivation underlying the decisions and adjust their strategy accordingly.
Gaming the System
VWAP evaluations judge some but not all trades correctly. Every good trader is aware of this half-truth, yet may not voice objections to a bad VWAP evaluation for fear of appearing defensive and obstructive. The plan sponsor using VWAP to evaluate managers trading needs to be careful to not confuse scoring good with being truly effective. It would not help performance to force traders toward strategies at odds with the prime performance objective.
In fact, any savvy (but shady) trader can easily trade in a manner guaranteed to look good against VWAP:
Never buy stock late in the day when the price has been trending upward. Trade as little as possible and hope for a more forgiving VWAP comparison tomorrow.
Try to mimic the VWAP by trading small amounts all day long, irrespective of manager motivation. Think of this as clock trading: executing orders on the basis of the hour and minute rather than prevailing market action. With enough trades executed at clock times during the day, the average price will come close to VWAP.
Refuse block liquidity when the price will compare poorly to VWAP. Better to stretch the trading out into many small executions, even at the risk of missing opportunities to complete large trades at effective prices.
Any price is a good price if the size of the trade dominates volume and thus VWAP. Trading that dominates VWAP is evaluated as quality trading no matter how expensive the price might be compared to manager decisions targets.
Conclusions
VWAP analysis works best comparing simple market executions for smaller trades under low motivation conditions. It tells the truth, but not the whole truth. VWAP analysis may be misleading, self-fulfilling and even self-defeating under every day institutional trading conditions such as rapidly changing market conditions, trades motivated by current news and recommendations, trades that dominate daily volume, principal trades, and trades whose execution stretches out over several days.
Finally, VWAP analysis may mislead when traders or brokers have the discretion – or the necessity – to defer trading to a subsequent day or to cancel trades when prices move too fast. At worst, VWAP makes the trader insensitive to price. Any price becomes as good as any other price. This denigrates trader skill and can destroy the value of research. In contrast, traders who truly understand the symbiotic linkages to research can actively promote and secure better performance.
In truth, VWAP’s shortcomings have long been recognized. As early as 1986, Barr Rosenberg stated:
"We have to look at this [VWAP] measure as very beneficial for screening people who don’t know it’s being used to evaluate them...[A]nyone who knew they were going to be evaluated by this measure would be some combination of dumb, impotent, or corrupt, depending on how they behaved. Dumb if they didn’t figure they could game it, impotent if they were incapable of gaming it and corrupt if they did...A fourth possibility [is] the saintly mode, where even though you know you can game this method you don’t game it."
Of course, we think we know a superior method for tracking implementation costs. If you had "X" dollars before the transaction and "Y" dollars afterward, it cost you "X-Y" to complete the trade. Unfortunately, VWAP can’t make this simple, complete computation.
Notes:
1. A simpler method of approximating VWAP is to add the Open, Close, High and Low prices and divide by four.
2. The SEC defines "best execution" as "the best available price in any market at the time of the trade." By VWAP accounting, however, both traders receive inferior prices relative to VWAP.
3. Similarly, at times the brokers willing to commit capital to expedite a customer’s trade can rank poorly against VWAP compared to brokers who execute simple, balanced market orders.
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© 1999 PLEXUS GROUP |
