A portfolio construction model outputs target weights. The execution problem is: given that you need to go from the current portfolio to the target portfolio, which sequence of orders minimises the total cost? The answer depends on urgency (how quickly the signal decays), order size (how much impact it generates), and market conditions (whether the stock is trending or mean-reverting during execution).
The central metric for execution quality is implementation shortfall (IS): the gap between the return you would have earned if all shares were traded instantly at the decision price, and the return actually earned after accounting for the prices at which the orders were filled. IS is to execution what the Sharpe ratio is to signal quality — the single summary number that tells you how much cost the execution process added relative to the ideal.
This note derives the IS decomposition, explains VWAP and TWAP as practical execution benchmarks, and connects them to the trade-speed decision for a stat-arb mean-reversion strategy.
Learning objectives. By the end of this note you should be able to:
- define implementation shortfall and decompose it into delay cost, market impact cost, and timing risk;
- describe VWAP and TWAP schedules and explain how they arise from different execution objectives;
- explain the self-referential flaw in using VWAP as a performance benchmark for large orders;
- connect signal decay to the urgency of execution for mean-reversion strategies;
- explain what a trading footprint is and why eliminating it reduces market impact.
In this lesson
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- Implementation shortfall
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- TWAP: time-weighted average price
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- VWAP: volume-weighted average price
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- Aggressive vs passive execution and the urgency decision
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- The footprint problem
Before you start
The full lesson, with worked examples and exercise solutions, is for members.
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