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Trading Costs

Gary Karz, CFA (email)
Host of InvestorHome
Principal, Proficient Investment Management, LLC

     Transactions Costs or Trading Costs (TC) are terms commonly used in the investment business to identify the cost of buying and selling securities (usually common stocks). There is some debate and/or confusion regarding defining trading costs since some participants use different metrics like Value Weighted Average Price (VWAP) as a definition, but most people define trade costs (in the Implementation Shortfall spirit) as the difference between an investor's average trade price versus either 1) the last price traded or 2) mid point of the bid-ask spread when the investor began trading.

     For small trades in liquid markets trading costs can be miniscule, but they can be substantial for large trades especially in less liquid markets. For instance, an investor buying 100 shares of a common stock or ETF on the open or close may have virtually no cost, but a large hedge/mutual fund complex trying to sell millions of shares of a smaller capitalization stock that just announced weaker than expected earnings may have costs of several percentage points. While many firms have a one-day trading horizon, larger firms often trade illiquid orders over several days, and some trade weeks, or months on the same order.

     While trading costs have not been a required disclosure for mutual funds, they have become more transparent of late. Mutual funds are required to report three years worth of commissions, which are one component of trading costs. Many firms calculate TC internally or via outside vendors and recently academics and others have started estimating the costs fairly effectively using publicly available information.

     There are many firms that offer Transactions Costs Analysis (TCA) to large investors (see Transaction Cost Analysis directory from AdvancedTrading), but the commonly recognized pioneer in the field of transactions costs and implementation shortfall analysis was a firm named Plexus Group (founded in the 1980s). For more on the history, see The Incredible Story of Transactions Cost Management: A Personal Recollection by Wayne Wagner in the Summer 2008 issue of The Journal of Trading (or here via Plexus was sold to JP Morgan Chase in 2002 and JPM then sold the firm to ITG in 2006 (I joined Plexus in 1998 and worked at the twice merged company until the end of 2009).

     ITG generally posts statistics from their universe quarterly. For instance their Global Trading Cost Review: 2009 Q4 includes data from Q205-Q409 for US (Large and Small Caps), Europe, Asia, and Emerging Markets. Their Total Costs are commissions plus Implementation Shortfall (IS) Costs (defined on page 11), but opportunity cost on unfilled orders are not included. Many of the statistics are intuitive, for instance large caps generally have lower trading costs than smaller cap stocks and developed foreign markets tend to have lower costs than emerging markets.

     In Scale Effects in Mutual Fund Performance: The Role of Trading Costs, Professors Roger Edelen, Richard Evans, and Gregory Kadlec estimated equity trading costs and determined that they are comparable in magnitude to the expense ratio (144 bps versus 123 bps, respectively). They also found that flow driven trades are significantly more costly than discretionary trades. Average annual trading costs ranged from 77 bps (large cap funds) to 285 bps (small cap funds) whereas average expense ratios ranged from 112 bps (large cap funds) to 134 bps (small cap funds). They suggest that funds with large relative trade sizes trade well beyond the point of cost recovery. According to their data (See Table IV on page 38), commissions were flat at .13% from 1995 - 2005, but spread dropped from .27% to.06% and price impact dropped from .93% to .26%.

     Returning to the issue of defining trading costs, in The Expanded Implementation Shortfall: Understanding Transaction Cost Components Robert Kissell (JP Morgan May 2006) differentiates and discusses 9 costs. A thorough discussion of the debate is also included in The Hidden Costs of Mutual Funds from the WSJ (3/1/10). While Morningstar has been mentioned as a future provider of trade cost estimates, they have not formally rolled out a service yet. See Morningstar to offer predictive power in FT (6/3/9) and Morningstar to Shine Light on Fund Trading Costs from Ignites, both via Reflow.

     Goldman Sachs Electronic Trading Research is a great starting point for those interested in further education about the world of institutional equity trading. There is a common misconception that using a passive trading strategy (using limits for instance) to capture spread or trading gains is a simple way to always lower costs (with no repercussions). In reality, trading passively exposes the trader to adverse selection (the possibility that the trades they do complete will underperform the trades they don't do) and often ignores the opportunity cost. Including the opportunity cost, it's not uncommon for total costs to be higher for passive orders than aggressive orders. See COPE and the all-in cost of passive limit orders by David Jeria, Tom Schouwenaars, and George Sofianos. They write that "relatively high all-in cost of the passive limits highlights the fallacy in the widely-held view that passive orders Ďcapture spreadí. This misconception results from ignoring the clean-up cost of the non-filled shares." See also The all-in cost of passive limit orders from the same authors (5/18/9) and "Natural Adverse Selection" from David Jeria and George Sofianos (Jan 2009). "Optimal Participation Rates and Short-Term Alpha" (via the Research link) by Mark Gurliacci, David Jeria, from George Sofianos (9/30/9) is an interesting article that discusses the optimal participation rate for traders with illiquid trades for balancing the impact costs with need to complete the trades at a reasonable speed.

     In Portfolio Transactions Costs at U.S. Equity Mutual Funds (See also Mutual Fund Brokerage Commissions January 2004) Jason Karceski, Miles Livingston, and Edward O'Neal estimated equity funds incur an average annual explicit brokerage commission of 38 basis points and an average annual implicit trading cost of 58 basis points (using 2002 data). They found about 46% of all small cap mutual funds have trading costs that are higher than the annual fees investors pay. They suggested that many mutual fund investors are completely unaware of these trading costs and simply assume that the reported expense ratio includes them. Investors can attempt to access the data from the source Statement of Additional Information (SAI) via the SECís Edgar database.

     Attempts to analyze fixed income (Bond) transactions costs have been thus far less common, but progress has been made. There clearly are real costs in fixed income trading especially when an investor buys from a broker's inventory (in which case the price may be marked up significantly) rather than on the open market. The methodology for analyzing bond trading costs has historically been hampered in part due to a lack of transparency and market data for many fixed income securities. See Corporate Bond Trading Costs: A Peek Behind the Curtain (JOF) April 2001 (earlier version) in which Paul Schultz estimated average round-trip trading costs to be about $0.27 per $100 of par value.

     In Corporate Bond Market Transaction Costs and Transparency (June 2007, Journal of Finance), Amy Edwards, Larry Harris, and Micheal Piwowar summarize the improvement in transparency of corporate bond trading using NASD's TRACE (Trade Reporting and Compliance Engine) data from Jan 2003-Jan 2005 (12,320,016 trades, representing 9.3 trillion dollars of volume). The system became operational on July 1, 2002. By the end of their sample period, prices from about 99% of all trades representing about 95% of the dollar value traded were disseminated within 15 minutes. They "found that transaction costs were lower for transparent bonds than for similar opaque bonds, and that these costs fall when a bondís prices are made transparent. We interpret these results as evidence that transparency has improved liquidity in corporate bond markets." They found that corporate bonds are expensive for retail investors to trade. Effective spreads in corporate bonds averaged 1.24% of the price of representative retail-sized trades ($20,000). See page 42 which has a useful graph of expected costs by size of trade dropping from about 0.75% for smaller trades to only a few bps for very large trades.

     The Cost of Active Investing by Ken French was the Presidential Address in the Journal of Finance (August 2008). Using information from the Financial and Operational Combined Uniform Single (FOCUS), which include broker's commmissions and gains/losses from market making French's trading costs are much lower than other estimated trading costs presumably because he intentionally does not include impact between investors (which are a transfer) and not a cost to society. French estimated a 92% reduction in trading costs, from 146 basis points in 1980 to a tiny 11 basis points in 2006. As Ken French and others point out, the trading costs do not necessarily reflect a cost to society, in fact much of the trading costs are transfers from one investor to another (but they represent lost alpha in the Implementation Shortfall methodology regardless). They represent a difference between what a costless investor (or paper portfolio) can achieve and what the actual investor achieved.

     Let's take a trading cost example. Let's say Jane and Jon are at a computer show. They are at an exhibit where the presenter shows them a new device that has both of them saying "that's really cool." The presenter tells them the device will go on sale the next day and he expects it to be a big hit. One of them jokes maybe its a good time to buy the stock. They both chuckle and walk away.

     Jan opens up her laptop and immediately puts in an order through her discount broker to buy 100 shares of the company, which is trading at $10. She pays an $8 dollar commission and crosses the bid-ask spread (paying 10.02) with a net cost of .1% or 10 basis points. Let's imagine Jon is a successful hedge fund manager. As he walks away he calls his head trader and tells him to buy up to 1 million shares of the stock, or whatever he can get by the close that day. At first his trader starts getting decent size trades, but then the supply of sellers dries up and the market seems to sense something is going on. By the end of the day they have filled half the order and the stock is up 7% to $10.70 (their average cost for the 500,000 shares comes to 5% or 500 basis points).

     By the open the next day, several favorable online articles have appeared about the device and the stock is up on the open another 3% to $11. Jane is ecstatic, because she's up almost 10% in one day. Jon is both happy and sad. He payed 5% for the shares he got and they are up almost 5% (his shares cost $5,250,000 and are worth $5,500,000 for a gain of just under 5% gain). But he only got half the order traded, so he has an opportunity cost of -10% on the 500,000 shares he didn't get. His implementation costs for the million share order is the trading cost (50% times -5%) plus the opportunity cost (50% times -10%) or -7.5%.

     Ultimately best execution, though frequently mentioned, has not been defined by the SEC. Some firms might consider best execution beating an average price over a certain period of time, while others might consider Implementation Shortfall or price move from start time to be the metric for determining the best execution. The CFA Institute's Trade Management Guidelines is one of the most informative reads on the subject. The Guidelines are divided into three areas: (1) Processes, (2) Disclosures, and (3) Record Keeping.

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