Trading Costs Research Paper Starter

Trading Costs

(Research Starters)

Trading costs are defined as the costs associated with trading securities. Trading costs are impacted by explicit costs, bid-ask spread, market impact and opportunity costs. Actively managed funds incur much higher costs than passively managed index funds or broad-based exchange funds. Over the life of an investment fund, the trading and management costs can have a significant negative impact on portfolio return. Many of the costs associated with trading are hidden from investors. Hidden costs include: Brokerage commissions, direct trading costs and soft dollars. Soft dollars, or in-kind business agreements, are exchanges between institutional investors and service providers. Soft dollars are under scrutiny by Congress and the Securities and Exchange Commission and will require greater disclosure to account for where soft dollars are actually being applied. Trading costs associated with mutual fund trading comprise a significant amount of money for investors over time and can adversely affect wealth creation for individual investors. Savvy investors will educate themselves about all the costs associated with their investment funds and look for better investment opportunities. Two such options exist in low-cost funds such as passively managed index funds and exchange-traded funds which incur significantly lower trading costs to investors over the life of their investments.

Keywords 12b-1 Fee; Bid-Ask Spread; Brokerage Commissions; Buy Side; Exchange Traded Fund; Expense Ratio; Index Fund; Mutual Funds; Net Asset Value; Opportunity Costs; Portfolio Turnover; Research Services; Sell Side; Transaction Costs

Finance: Trading Costs


A recent study entitled "Scale Effects in Mutual Fund Performance: The Role of Trading Costs" by Gregory Kadlec, Roger Edelen and Richard Evens examines the effects that different trading costs have on mutual fund performance. The trio studied the performance of 1,706 funds from 1995-2005 in what may be the most comprehensive study to-date about the factors that affect mutual fund performance — specifically related to fund trading and costs. "Scale effects in trading, rather than other factors in fund management are the primary cause of diminishing returns to scale in the mutual fund industry" (Wasik, 2006).

The trading costs associated with mutual funds are significant to this discussion because of the significant numbers of individual investors that have money invested in these funds. About 50% of adults invest in mutual funds, according to 2006 estimates and the number is expected to grow. Mutual funds are popular with individuals because they offer professional portfolio management across a diverse number of funds and require a minimum investment to get started. Mutual funds are a ubiquitous investment choice for Americans and an investment option that most working persons are familiar with. Many of the trading costs associated with mutual funds are also associated with trading of stocks and other securities. This essay discusses common trading costs associated with trading stocks and those costs that are unique to mutual fund trading.

The Two Trading Costs

Trading costs can add up for investors in a number of ways, but there are really two distinct costs associated with trading. They are:

  • Gross cost, or, the total cost to trade (brokerage commission, bid-ask, cost per trade-market forces).
  • Net cost, or, the cost of fund performance caused by trading (portfolio turnover and scale effects).

Gross costs can be broken into a number of generally agreed upon categories. These include:

  • Explicit Costs (brokerage commissions, fees and taxes).
  • Market Maker Spread (also known as the bid-ask spread and is essentially the difference between the bid and ask prices that the fund specialist sets for a stock; the specialist keeps the difference as compensation for facilitating the "deal").
  • Market Impact (the affect that high volume trades have on influencing the market. The impact can be temporary or permanent).
  • Opportunity Cost (cost of a missed opportunity or next best choice when making a trading decision. In trading, there is a price movement that occurs before the trade executes) (Trading Costs, 2007).

Expense Ratios

A mutual fund's expense ratio is the measure of what it costs an investment company to operate a mutual fund. This figure is readily available to the investor and includes operating expenses, management fees, administration fees and all asset based costs. Expense ratios do not include brokerage fees, trading fees or soft dollar costs. The Net Asset Value of a fund records all fund expenses but doesn't break out some of the hidden costs, making many trading costs invisible to the investor.

Fund operating expenses vary widely depending on the type of fund. The largest component of operating expense is the fee paid to a fund's investment manager/advisor. Other costs include recordkeeping, custodial services, taxes, legal expenses, and accounting and auditing fees. Some funds have a marketing cost referred to as a 12b-1 fee, which would also be included in operating expenses. Curiously, a fund's trading activity (the buying and selling of portfolio securities) is not included in the calculation of the expense ratio (Investopedia, 2007).

Trading costs associated with mutual funds impact individual investors in obvious and non-obvious ways; specifically through the gross and net costs defined previously. Trading costs associated with buying and selling stocks and securities also have a great impact on retail and institutional investors. Trading costs can adversely affect the performance of funds for investors as will be shown in subsequent discussions. Non-obvious costs such as brokerage commissions and soft dollar costs can affect fund performance and add on significant costs for investors. Much scrutiny has been given to the need for increased disclosure and transparency in documenting trading costs for investors. This essay will outline legislative efforts that are underway to offer investors information regarding "hidden" trading costs. Alternatives to costly managed funds, such as index funds and exchange traded funds will also be discussed. Passively managed index funds and lower-cost exchange traded funds (ETFs) can increase fund performance and shareholder value through reduced trading costs for investors and significantly improve return on investment.


Brokerage Costs

Brokerage commissions have long been public, albeit buried in fund prospectuses and documents called Statements of Additional Information. Despite this, commissions account for only about 20% of the true costs of trading (Goldberg, 2007).

Broker commissions may only account for 20% of the true costs of trading, but there is still room for abuse in passing along the cost of inflated commissions to investors. Because broker commissions are not revealed in expense ratios, the costs are often hard to discern.

The following example illustrates how broker commissions can affect a fund's performance when other factors are equal. This example examines two funds (Fidelity Discovery and Mairs & Power Growth) that reported similar (strong) market returns and identical expense ratios in the same year.

"Both funds charged 0.7 percent for finding large-company stocks trading on the cheap. Those expense ratios, however, don't tell the whole story. All funds (even index funds) ring up brokerage costs when they buy and sell stocks — costs that aren't included in the expense ratio. Instead, they are plucked from a fund's assets — and they add up quickly" (Wherry, 2006). By flipping its portfolio 2.3 times in 2005, Fidelity Discovery racked up $65 in brokerage commissions for every $10,000 invested, nearly doubling the fund's published expenses. Meanwhile, Mairs & Power Growth, known for its long view, sat on its picks. Its tiny 3 percent turnover added just a penny in trading costs. (That same year, Mairs & Power Growth gained 4.4 percent, versus Discovery's 2.1 percent return — though the disparity isn't due solely to trading costs) (Wherry, 2006).

Broker commissions are directly related to portfolio turnover because brokerage costs get rung up every time stocks are bought and sold. Flipping a portfolio can rack up big commissions, but doesn't necessarily benefit the investor as is seen in the example above.

Mutual fund brokerage commissions and implicit trading costs vary significantly among various types and styles of domestic equity funds, and when summed they are not infrequently larger than a fund's regulatory expense ratio. This is true in the current study for the Vanguard 500 Index Fund. The continuing bad news is that disclosure of brokerage commissions and implicit trading costs remains effectively hidden and completely hidden, respectively, from fund shareholders (Haslem, 2006).

Portfolio Turnover

Portfolio turnover, as previously discussed, has a direct affect on brokerage commissions; every time a stock is bought or sold, trading costs add up. There's no evidence that portfolio turnover positively impacts a fund's performance, often because value is eaten up by higher trading costs and commission rates.

Studies have failed to find any long-term causal correlation between higher priced investment managers and more robust return on investments. Admittedly, as with most rules, exceptions do exist, and you may find a pricey manager who can demonstrably handle your plan investments with an excellence that warrants the extra cost. Over time, though, such exceptions are rare. If plan assets are invested in high-turnover funds, the upfront management fees may look fairly innocuous, but that may mask the fact that trading costs are capturing even more of your assets than the management fees themselves. Studies have shown high portfolio turnover rates can add significant additional amounts to the total cost of plan investments (Bowe, 2006). "Portfolio turnover [a hot topic these days] is a measure of how frequently a portfolio's securities are bought and sold. Turnover in a portfolio has a cost — the cost of buying and selling securities or other investments. A 100% rate, for instance, would signal that your fund manager, on average, doesn't hold any investment in the portfolio for more than a year" (Bowe, 2006).

Scale Effects on Mutual Fund Performance

The 2007 report titled "Scale Effects in Mutual Fund Peformance: The Role of Trading Costs" states that buying and selling stocks costs an averaged of 1.44% annually in fund trading costs that are passed along to investors. What kind of fund is traded and why the fund manger is buying or selling a stock also impacts the costs to investors. Trading does tend to boost performance when managers make informed...

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