In focus

The transaction costs manual: our "how to" guide to a complex topic

In this paper we (attempt to) tackle the complicated issue of transaction costs. We outline what one needs to know about reported transaction costs and explain how to avoid common pitfalls when using them.

To cut what is a very long story short:

  • transaction costs are a necessary part of investing;
  • estimating them is complex;
  • no two trades are the same so transaction cost figures should not be compared in isolation;
  • and, finally, higher transaction costs do not mean a more expensive fund or lower returns.

At the end of the day, all transaction costs, measurable or not, are embedded in the returns investors get.


Although, to the wider world, January 2018 did not signify anything extraordinary, it did mark a new era for costs and charges transparency in the investment fund market. The two pieces of European regulation that came into force at the time – the Markets in Financial Instruments Directive II (MiFID II) and the Packaged Retail and Insurance-based Investment Products (PRIIPs) – have been a game changer in the way the cost of investing in a fund is communicated to investors. For the first time, people were able to see not only the ongoing cost associated with being invested in a fund but also how much the transactions carried out by portfolio managers were costing them in total. In parallel, new rules came into force in the UK requiring the reporting of transaction costs for workplace defined contribution (DC) pensions.

There is a certain mystique about transaction costs. Some of it has to do with long-standing suspicions that they are hidden. Some of it is because a part of transaction costs is so intangible that it borders on theoretical. At the time when the new disclosures came into play, many attempted to explain what the numbers meant and how they should be interpreted. But the transaction cost mystique is persistent. Despite everyone’s best efforts, almost three years into MiFID II, we observe three common pitfalls among users of the disclosed transaction cost figures:

  • Comparing the transaction cost figures of different funds in isolation, that is, without accounting for any other fund characteristic, market conditions or investors buying into or selling out of a fund.
  • Considering that higher transaction costs mean a more expensive fund.
  • Expecting that lowering transaction costs will result in higher returns.

The purpose of this ”manual” is to explain exactly why all three assumptions are wrong. To do this, we need to go back to basics, to cover the technical aspects behind transaction costs and explain the many intricacies around how they are connected to fund types and returns. We do this in four parts.

The first part of the manual starts with what transaction costs are, explains why some are intangible and discusses how they relate to another technical term: “best execution”.

The second part covers the critical question of how one can measure transaction costs and outlines the challenges with estimating the overall cost of trading.

The third part explores how transaction costs are connected to returns and why their relationship is not linear.

The fourth and final part of this manual brings everything together to answer the most important question: how to use and not use reported transaction cost figures.

Where relevant in this four-part manual, there is empirical analysis which is based on MiFID II transaction cost figures. The PRIIPs disclosure regime remains so fraught with issues – which, almost three years since its introduction, remain unresolved – that it is not covered here. As an indication of how complicated this is, suffice it to say that cost disclosure in PRIIPs is not consistent with that in MiFID II, so that investors see different numbers for what should be the answer to the same question: how much did I pay? The debate around this is currently ongoing. Despite this, how transaction costs are estimated and presented to investors does not alter what these figures mean and how they can be used.

If there is one thing people should take away from this manual, it is that this is a complicated matter, but understanding it is necessary in order to use transaction cost figures in a meaningful way. It is not meaningful to look at them out of context or to compare transaction cost figures in isolation, as no two trades are the same. And, even if there is no one reliably exact way to estimate total transaction costs, these costs are fully reflected in the returns that investors receive.


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