Transaction costs explored
There is most definitely a mystique around the subject of transaction costs. Some of it might have to do with long-standing suspicions that they are a secret club, one which many of us are not allowed entry to. Some of it is perhaps because transaction costs are the least tangible part of investment; we know they are there, but it is quite hard to put an exact figure on the impact they might have.
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In the first of our ‘Fiduciary Management Insight’ series, we look to help Trustees gain a foothold in the area of transaction costs. As fiduciary selection and oversight activity accelerates, transaction cost analysis is starting to become a far more regular feature in our reporting as well as the interactions with both our clients and their advisors.
The very nature of a fiduciary relationship, with the increased scope for outsourcing of investment decision making and implementation, requires that Trustees have confidence in the capabilities and values of their manager. The area of transaction cost management and reporting is no different. Trustees should gain the necessary comfort that their manager has the appropriate investment implementation resources, governance structures and reporting capability to manage transaction costs and deliver meaningful transparency.
As we will explore, the concept of best execution is critical to managing transaction costs. Having the right infrastructure and the right governance structures are pre-requisites to successfully managing transaction costs.
What do we mean by transaction costs?
Anyone who wants to make an investment – be it a do-it-yourself investor or a fund manager – has to undertake transactions, that is, buy and/or sell securities. This is how investment returns are generated, but transacting is not frictionless and it generates cost. Transaction costs arise for different reasons. Some reflect an actual payment to a trading venue or intermediary to complete the transaction (“explicit”) and some reflect the theoretical value that is lost to the market during the process of buying and selling (“implicit”).
Definitions
Commission: Commission is the payment to the third party who executes the transaction such as a broker. More often than not, the commission will include other fees such as an exchange fee, which is the price one has to pay for buying or selling a security in a specific venue.
Tax: This is the payment to the local revenue or tax authority and it is literally a tax on transacting. For example, there is a Stamp Duty Reserve Tax of 0.5% when one buys shares of a UK company.
Bid/Offer spread: This is the difference between the price one is willing to pay to buy a security (“bid”) and the price one is willing to receive for selling the same security (“offer”).
Market impact: Market impact is not as easy to measure as the spread. To understand what it is we need an example borrowed from economics. An order to buy a security means higher demand for that security. All else being equal, higher demand means a higher price. So, placing the order to buy signals higher demand and, by the time the order is completed, the price may have moved slightly upwards. It does not mean that money flowed out of the fund. It means that a small element of value was lost because one ends up buying at a slightly higher price than when the trade was initiated. Of course, this works the other way around when one sells something.
Delay costs: Delay costs exist because of market impact. Larger orders create greater supply-demand imbalances which affect liquidity and translate into greater price movements in the “wrong” direction, as in our previous example of paying a higher price because of the strong demand signal that a large order to buy a security has sent to the market. One can manage this by splitting up the big trade into smaller ones, on the expectation that the combined impact of the small trades will be lower than that of the single large trade.
Looking in more detail at each of these:
- Explicit transaction costs refer to a very specific amount that is paid to known parties in order to carry out a transaction. These costs are obvious when they occur and directly reflect an outflow from the fund’s assets. There are two such types of payments: commission and tax.
- Implicit transaction costs do not reflect money that is paid out in order to complete a transaction. Rather, they reflect the value that is lost in the market infrastructure and are therefore perhaps better characterised as friction. The general consensus is that there are three types of implicit cost, that is, three ways in which value can be lost during a transaction due to market friction: 1) through the bid-offer spread, 2) because of market impact, and 3) due to any delay in completing a transaction.
We often find that the implicit costs are the major component of total trading costs.
Where does “best execution” fit in?
As mentioned, transaction costs exist because buying and selling securities, in other words, trading, is not frictionless. Since this friction translates into lost value, we transact on behalf of clients to minimise the value that is lost by optimising the way we trade. This is what “best execution” is. In simple terms, it means executing a trade in the best possible way.
What makes execution the “best”?
The MiFID II regulation defines it as the “best possible result … taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order”. The cost of trading (transaction costs) is one factor that is used to assess best execution, but cost is not the only factor. Best execution is a broader concept that also considers how fast a trade is completed (as time delay can create friction) as well as the likelihood that it is completed at all.
In trying to achieve best execution, the trader will take into account many different (sometimes conflicting) factors at the same time, such as:
- The price of the security that is being traded;
- The liquidity of the security;
- The size of the trade compared to the total volume that is traded;
- The orders that are being filled by other market participants;
- The urgency in completing the trade and;
- All the possibilities to fill that order (through different brokers, at different trading venues, etc.)
What is needed to achieve best execution?
1. The right infrastructure
Best execution is not only about the actual outcome but all the possible outcomes. Part of this concerns the infrastructure that a trader has in place for executing trades. This involves the “nuts and bolts” of actual hardware and electronic systems. It also involves having access to different brokers, markets and trading venues in order to identify the best terms. Having access to ‘everything and everyone’ is crucial for best execution as markets become increasingly fragmented and the same security can be traded in multiple venues at different volumes and with different market participants.
At Schroders, we have a number of ways to define and monitor best execution. For example, we use transaction cost analysis (“TCA”) to assess trading performance for equities, foreign exchange and fixed income. This data is reviewed to identify outliers, individual executions that have a high cost, and to analyse trading strategy and counterparty execution performance.
We make use of a variety of different trading techniques and venues to keep dealing costs low. For example, liquidity considerations can be built into investment processes in order to keep market impact costs to a minimum. Our use of trade cost analysis (TCA) also helps us modify our trading methods to improve trading performance; for example, finding the optimal speed of release of orders to the market or choice of venue.
2. The right governance structure
There is also a strong element of governance in all this, even though governance is not explicitly mentioned in the best execution regulations. This relates not only to specific policies but to a set structure and framework to ensure ongoing oversight of trading processes and outcomes. Good governance and oversight within best execution should prevent inefficient trading that results in unnecessarily high transaction costs and lower value for clients.
Having separate portfolio management and trading functions is essential. The portfolio manager makes the decision to trade but it is the trader who is responsible for executing each trade subject to any restrictions or conditions imposed by the client. Trade execution may include the use of algorithms, which could be provided by a broker and which are designed to minimise cost, either in the form of market impact from a large order or the cost of filling many small orders. It may also include advance orders whereby a trade (or part of it) is executed only if specific conditions are met, such as the price having a set distance from a benchmark. After all, best execution is about achieving the best possible result for the client.
Our integrated Fiduciary Management solution means our clients benefit from a joined up platform where we can manage costs effectively. Our clients have growth portfolios with a separate growth portfolio management and implementation function. We are extremely cost-aware. Before implementing a new investment idea in our clients’ fiduciary portfolios, the costs of adding the new position and selling existing holdings are considered. We often minimise costs when adjusting asset allocation by using derivatives, in particular futures. This is an efficient way of implementing shorter-term asset allocation decisions since it is less expensive and quicker to transact than implementing decisions via adjusting the underlying physical portfolios.
What is the relationship between transaction costs and returns?
Transaction costs are fully embedded in the return. For example, if a trader does not achieve a favourable spread and ends up buying a security at a higher price than that intended, then any future return will start from a higher cost base and thus be lower (all else being equal).
At the same time, the transaction cost figure itself says very little about what return will be achieved later. The future return is the outcome of the transactions that create the portfolio. A different set of transactions with the aim of achieving a lower transaction cost figure would mean trading in different securities, in different amounts, under different market conditions. This would result in differences in the portfolio and there is no way of knowing in advance whether this will be higher or lower.
Sometimes, it is worth incurring a relatively high transaction cost to ensure that a trade is completed in a timely manner. The urgency of the trade, which is a function of both market liquidity and expected price movement, is as important as its price. That is why “managing” is a more appropriate term than “minimising” when it comes to transaction costs and best execution.
This is not something for which a specific formula exists. It is often a judgement call for the trader, who needs to keep an eye on market liquidity, on how many other market participants are out there who would be willing to trade, whether there are too many wishing to make the same trade, thus making it harder to find someone to take the other side of the trade, and so on. How effective the trader is in managing all this, will show in their ability to execute trades, to do so in a timely manner and at a good price, without incurring excessively high transaction costs in the process.
These complexities can make it difficult to compare published transaction cost information.
Figure 4 shows analysis of portfolio returns compared to MiFID II transaction costs. You might expect a downwards sloping line: low transaction costs = high returns and vice versa. However, we see that actually any given level of transaction costs can be associated with both high and low returns. Mapping these aggregate MiFID II transaction cost figures against the corresponding returns shows a cloud of dots with no observable relationship. Different transactions mean a different portfolio composition which means different returns. Even if the portfolio composition is similar, both in terms of holdings and exposure to each holding, transacting in the same securities at different times will result in different prices and hence returns. “Different” really means “different” in that one cannot know in advance if it is lower or higher.
Three common pitfalls to avoid when using transaction cost figures
There are three common pitfalls when using transaction costs which, perhaps unsurprisingly, are interrelated.
- Pitfall #1: Comparing the transaction cost figures of different funds without accounting for any other fund characteristic.
Firms use different methodologies to calculate their implicit transaction costs. Which means that implicit costs, and by extension total transaction costs, cannot be compared directly. But even if one common methodology were used, transaction cost figures should not be used in isolation. What is “high” depends on how much was being traded, under what conditions, whether it was driven by fund inflows-outflows or investment opportunities and what was the outcome. Ultimately, it is the net investment return that matters. A fund with a high transaction cost figure can be trading effectively if this reflects the required style of trading. - Pitfall #2: Considering that higher transaction costs mean a more expensive fund.
Transaction costs are not like ongoing charges where one could say that higher charges mean a more expensive fund. Higher transaction costs do not mean a more expensive fund. It means that a specific fund incurred higher transaction costs, which may be driven by a number of factors. Ineffective best execution is certainly possible but, with appropriate internal governance, this should be picked up and addressed accordingly. - Pitfall #3: Expecting that lowering transaction costs will result in higher returns.
It is always true that for two funds with similar holdings and thus, similar gross returns, the one with the higher ongoing charges will have the lower net return. If a fund decides to lower the ongoing charges then automatically (all else being equal) the net return increases. That is not true for transaction costs. If a fund decides to lower the transaction costs by transacting less or transacting in more securities with low trading costs then the fund will end up with different holdings and thus, a different return. It cannot be predicted in advance whether this return will be higher or lower.
Transaction cost figures do have a purpose. The intention behind requiring their disclosure is that, along with other fund attributes, they can give a fuller picture of what the fund is trying to achieve and how well it has achieved it. Transaction costs, particularly alongside information on best execution, can indicate how efficiently a manager has delivered against the investment objective.
Transaction costs should be seen not on their own but in the context of broader fund attributes such as:
- In what securities does the fund usually trade and what were the market conditions in the period reported?
- Is the fund actively or passively managed?
- What is the net return?
- What are the ongoing charges?
- What is the risk?
- How are transaction costs estimated?
- Are there any anti-dilution mechanisms in place?
Having an integrated Fiduciary Management model increases transparency and the ability to understand how the above questions impact your portfolio. We remove unnecessary layers, making everything more transparent and ensuring connectivity of solution components.
Some final thoughts
If there is one thing people should take away from this investigation it is that measuring the cost of trading is a complicated matter and understanding all aspects is hard. As reporting of transaction cost figures becomes more widespread, using transaction costs for investment decision making is becoming more common and therefore an understanding of some aspects is necessary in order to use transaction cost figures in a helpful way.
To reiterate: there can be no returns if there are no transactions. One has to buy or sell something at some point to get a return. Returns are the outcome of transactions but this does not mean that there is a linear cause and effect between transaction costs and returns.
High transaction costs are not necessarily bad and they certainly do not mean a ‘more expensive fund’ as they can result in both higher and lower overall returns. Lowering transaction costs will not necessarily result in higher returns. What we can say with certainty is that a different set of transactions will result in a different level of return and that the outcome of these cannot be predicted in advance. But the good news amid all this uncertainty is that returns will always reflect all the transaction costs incurred.
As we have discussed the implementation of best execution is critical to managing transaction costs. At Schroders, our focus on having the right infrastructure, the right resource and the right governance structures is essential to successfully managing transaction costs. Just as important is the right culture, a culture of disclosure and of being close to your clients, of delivering the right information and the right support to facilitate meaningful interpretation of that information. All of these features become magnified in a fiduciary relationship, where Trustees are outsourcing both day-to-day investment decision making and implementation. Our approach, removing layers between our clients and their investments, allows us to provide unique levels of oversight which delivers the effective investment governance that Trustees entrust us with.
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