Exploring the benefits of MOC trading in transition management

Key takeaways:

  • While Implementation Shortfall (IS) is the industry standard benchmark for transparent transition performance, Market on Close (MOC) trading can still be a valid trading strategy despite its potential impact on IS.
  • MOC trading can align with pricing points, reduce out-of-market risk, and simplify transitions in scenarios like pooled fund subscriptions or redemptions.
  • For highly liquid securities, MOC trading can reduce risk and simplify strategies with minimal price impact, leveraging increased trading volumes at the market close.
  • Incorporating MOC trading, when used appropriately, can help fulfil client objectives.

When benchmark transparency meets the complexities of designing transition management trading strategies, where can MOC trading enhance outcomes for clients?

For over two decades, Implementation shortfall (IS) has been the benchmark for measuring transition performance. Trading strategies like MOC, which inherently influence closing prices, have historically challenged the integrity of the IS benchmark, and have been rarely used when transitioning portfolios – but does this mean MOC is completely without merit in transition management?

This article will explore developments within financial markets relating to equity trading volumes at the market close and the utility of MOC trading to a transition manager when deciding on an overall transition trading strategy. It will also break down the key considerations surrounding the effects that a trading strategy like MOC has on IS as a benchmark.

What is MOC?

A market-on-close – MOC – order is a type of stock order that instructs a broker to buy or sell a security (or basket of securities) at, or as close to, the closing price of the trading day as possible. MOC orders are used to achieve the last possible price of a trading day. Using a MOC order ensures that the desired transaction is executed, but still leaves the investor exposed to end-of-day price movements, given the auction structure of MOC orders.
 
What is Implementation shortfall?

IS is the generally accepted industry standard for measuring the cost of a transition. First opined by Andre Perold in 1988, refined for specific use in transitions in the T Standard (2003) and adopted by the T Charter (a voluntary code of conduct in the TM industry) in 2007.

IS captures all the costs associated with a transition, including brokerage, taxes, fees, foreign exchange, bid/ask spread, pooled fund spreads, dilution levies, market impact and opportunity cost/gain. IS compares the actual transition portfolio return with that of the target portfolio return, assuming the new portfolio had been built the day before the transition commenced and at zero cost. A key component of IS is using the closing prices on the day prior to when any trading commenced as the benchmark; the point here is to use a "clean" benchmark i.e., one that has not been impacted by the trading you are about to undertake.

Why has MOC trading not typically been used in TM?

Before T Standard IS was adopted by the transition industry and became widely used, there were different approaches to reporting and performance evaluation, which had varying levels of transparency for clients.

The problem with MOC trading was that it directly impacted the benchmark you were measuring performance against. Transition providers could use MOC trading to make reporting appear more favourable by "muddying" the benchmark. Theoretically, a transition management provider who executed all trades for a transition at market-on-close would appear from a reporting perspective to have traded with zero deviation from the benchmark, even though trading in this way can lead to significant price impact and, importantly, delay trading and potentially result in poor performance.

This made it difficult for clients to accurately benchmark transition performance and therefore clients began to demand more transparent reporting standards. In response, the T-Charter was created (Russell was one of the founders) and this led to an industry standard for transition management benchmarking and reporting transparency.

Is MOC trading all bad?

IS is a methodology for measuring performance. MOC is a trading strategy. The two are different and recognising that trading on the close will impact closing prices means MOC should not be a transition benchmark because it uses a reference price that has been affected by the participant's activity. However, this does not mean that it is not a valid trading strategy, even for use in transitions.

When setting a trading strategy for a transition, our primary objective is to recommend what is in the best interests of the client, by understanding what their objectives and priorities are. We are flexible in our approach and will adjust our strategy if a client has a specific preference or requirement. In some events, MOC trading can be beneficial and additive to an overall trading strategy when used appropriately. In these cases, we will recommend it as part of the overall strategy.

When might MOC be appropriate?

  • Utilising MOC where events include pooled fund redemptions / subscriptions
    • Take the example where one side of a transition is either a subscription/redemption to/from a pooled fund and the other side is a segregated account.
    • Often the pricing point of such pooled funds is the market close. In this case, to match the pricing point of the subscription or redemption, we would place MOC orders for the other side of the trade, minimising out of market risk.

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  • Taking advantage of enhanced liquidity to achieve material risk reduction
    • For many years the volume of trading activity at the close has increased significantly.
    • For example, the average daily volume traded at the NYSE closing auction has increased by 37% since 2020. As a result, a very liquid trade (measured in terms of % of average daily volume ADV) may only have a negligible impact on the price if traded at the close.
    • In this case, we can adopt MOC where trading a liquid portion of the portfolio (for example <2% ADV) will materially reduce overall risk in the transition and would have minimal effect on the price due to its liquidity.
    • By trading MOC in this scenario you can reduce the complexity of the overall strategy by reducing the need to use futures for hedging country risk, and can reduce stock specific risk by targeting those names with the highest contribution to risk in the transition, which is a positive outcome for the client.
    • As managing risk is one of the key components in managing transitions, an MOC trade can be an important risk management tool in the transition manager's arsenal. An immediate risk reduction might also help reduce the potential opportunity cost of being in the legacy portfolio for a shorter period of time.

    The bottom line

    The T-Charter and IS were adopted by the transition industry to improve transparency for clients. The natural consequence of this was a move away from trading strategies such as MOC, which might impact that transparency.

    However, there could be times when a client wants to forgo a level of transparency if this helps reduce cost or risk during a transition. In such cases, it would be remiss of the transition manager not to explore and present all options available. While it is vital to highlight the pros and cons of incorporating an MOC trade, it is important that the client ultimately has all the options at their disposal to make the most informed decision possible.

    Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

    The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.

    Execution services are provided by Russell Investments Implementation Services Inc., member FINRA/SIPC.