Bank of America Merrill Lynch’s Josephine Kim lays out the reasons why the close price benchmark is so important and how experienced traders can utilize technology to meet the benchmark.
Close Price Benchmark
Mutual Funds Interest in the closing price is due to the structure of the market. Mutual funds are marked at the end of the day at the closing price. This is the published net asset value (NAV) that indicates that the mutual fund will be marked once a day, and where all the purchases and sales of that mutual fund will be marked at. This is a relic of the market structure of mutual funds. Now, mutual funds are not traded each year or all day long – buys and sells are made at any point during the day and the price is given at the market close. If mutual funds are traded on any given day, the mutual fund trader is going to attempt to get the closing price if at all possible.
Transition Trades Another way in which a trader would try to beat the closing price is via a transition trade. This is when a pension fund moves assets from one manager to another by selling the assets in one manager’s holding in order to buy the assets from another. The pension fund may go to a specialist transitional manager, who takes all the holdings from the current manager, sells them, uses the proceeds to buy the holdings for the new manager, and then passes those holdings back to the new manager. This process has a mark on valuation and the closing price is that mark.
Index Rebalancing The final type of trade that allows traders to beat the closing price is index rebalancing. Asset managers may opt for a guarantee on their trade. Brokers will bid aggressively for those trades with the same tradeoffs occurring. Index rebalancing trades have an additional nuance in that everyone in the market typically knows whether the street has to buy or sell a stock for the rebalance, so brokers will put out research ahead of the rebalance.
The brokers then have to make a tradeoff, knowing there is potential demand to buy or sell these stocks from many different buyers and sellers. Traders must decide whether to trade early because they know everyone is going to buy the stocks when the index weight goes up, or trade them later (or even the next day), because everyone is going to sell. In the last few years, more and more investors have the requisite information to make the right decision on rebalancing trades.
Implications of Missing the Close Price The implications of missing the close price benchmark are straightforward. If the trader purchases below the close price, the mutual fund investor buys the fund at a higher price than their investment, which creates transfer of wealth from the new purchaser to the shareholders of the fund. If the mutual fund is not able to beat the close price but requires funds in excess of the new investment, then the existing shareholders subsidize the purchase.
In a transition trade, missing the close price on the funds to sell and the funds to buy creates numerous problems. For transition trades, brokers will very often give an assessment of the expected range of slippage ahead of time, based on the liquidity of the portfolio they are trying to liquidate and the portfolio they are trying to invest in. The broker clearly hopes to land within that range. If they are outside that range however, the transitional manager might refund some of their fee or maybe even negotiate a profit share ahead of time to incentivize them to minimize slippage. Unless the transition manager is able to buy at a discount, missing the close price means a loss to the fund. This slippage can have major implications for the value of assets retained by the client.