Trading Costs

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

Overview

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.

Applications

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 decisions about trades and when executed, does add value to the fund. As much as 30% of all trading is executed due to investors moving in or out of funds. These trades are simply executed by a fund manager as a service to the investor, rather than a conscious, researched trade by the manager. Trading resulting from investors moving in and out of funds has been found to reduce fund performance by 1.4 % points per year. A similar scenario for trading has to do with fund managers rebalancing funds to stay within defined fund parameters. In both of these cases, trading is executed by a manger in an administrative capacity. Studies show that on average, every dollar spent on trading, costs investors 42 cents in fund performance. If one were to multiply the 1.44% spent annually on trading by 42 cents, the cost to fund performance is calculated at 0.60% of performance annually (Goldberg, 2007).

Large trades cost more to execute than small trades. A fund manager who wants to divest of a large number of stocks from a portfolio will sell blocks of stocks over time. Divesting of large numbers of stocks inevitably pushes the price of the stock down as a result of the increase of stock for sale (supply and demand). Delaying the sale over a period of time can also cost a fund (delays in selling can cost) which is also known as an opportunity cost. The report also points out numerous other factors that may affect trading costs.

Size of Company

Domestic stock funds spend an average of 1.44% annually on buying and selling stocks and every dollar spent on trading, costs investors 42 cents in fund performance (Goldberg, 2007).

Compare the trading costs in % listed below, and one can easily see how the size a company or the type of fund compares to the average of 1.44. To calculate the cost of performance to the fund one must multiply the % given by 0.42 cents.

The biggest predictor of total trading costs is the size of the companies in which a fund specializes. These percentages show the total annual trading cost passed on to investors. Trading cost for small cap companies are much higher than for large cap companies (Goldberg, 2007).

• Small cap companies = 2.85%
• Mid cap companies = 1.73%
• Large cap companies = 0.77%

Type of Fund

Another predictor of total trading costs has to do with the type of fund in a portfolio. Value funds cost less in terms of trading cost than do growth funds (Goldberg, 2007). Value funds are considered to be undervalued in price, while growth stocks are expected to grow at an above average rate relative to the market. Compared to the annual fund average of 1.44%, both value and growth stocks are higher than the industry average, but value stocks cost the investor less in terms of fund performance and therefore are a better place to invest.

• Value funds = 1.21%
• Growth funds = 1.84%

Size of Fund

Size of funds by asset has significant impact on the cost per trade. Larger funds with lots of assets suffered fund performance while fund performance improved for trades in small funds. These findings bolster the case for investing in funds with small asset bases to improve fund performance (Goldberg, 2007).

• Large funds. For every $1.00 spent on trading costs, large fund performance drops by 88 cents.
• Small fund. For very $1.00 spent on trading costs, small fund performance improved by 38 cents.

Issues

Soft Dollars

Soft dollars are payments made by institutional investors (administrators of mutual funds and other money managers) to providers of services such as trading and research. The difference between soft dollars and hard dollars is that instead of paying the service providers with cash ("hard" dollars); the mutual fund will pay in-kind with brokerage business ("soft" dollars) (Wayman, 2004).

Soft dollars don't leave a paper trail the way that hard dollars (fee for services) do. Soft dollar costs, most often designated for research, are hidden in trading costs and passed along to investors. The disadvantage to investors, of course, is that they don't have a direct way of analyzing the soft dollar costs between differing funds. Since soft dollars mix up research with trading costs, there's increasing suspicion around the practice. It is not a question of who will pay for the research costs; investors will ultimately end up paying for all costs associated with fund maintenance.

Soft dollars have been around since 1975 when their use was made legal by the addition of section 28(e) to the Securities and Exchange Commission (SEC) Act of 1934. Since then, the use of soft dollars has increased greatly and also the questions surrounding what services are actually being provided in exchange for the soft dollars.

The lack of transparency surrounding the use of soft dollars has sparked a number of regulatory and legislative efforts since 2001. The timeline below outlines some of the efforts by Congress and the SEC to address various issues (Bresiger, 2007):

• 2003 House Financial Services Committee hearings.
• 2004 Sen. Fitzgerald's Mutual Fund Reform Act.
• 2005 Mutual Funds Integrity and Fee Transparency Act.
• 2006 SEC interpretive ruling.
• 2007 Chris Cox letter to Congress concerning Soft Money.

The SEC's 2007 statement of soft dollars was clear in determining that commission revenues or soft dollars could be used for research as long as documentation exists to insure that soft dollars don't go toward funding overhead. Commission sharing, popular in the UK, was also supported by the SEC. Commission sharing states that funds can direct a portion of feed to cover broker/dealer trading costs and the remainder to research from a different source as long as there was full disclosure in accounting for the particular costs.

In 2007, Chris Cox (chairman of the SEC) sent a letter to Congress outlining four concerns regarding soft money:

• Soft dollars may create conflicts of interest between money managers and clients.
• Soft dollars may contribute to higher brokerage costs.
• Soft dollars are difficult to administer.
• Soft dollars impede development of efficient markets.

Research services from third party research firms were estimated at $9.31 billion in 2004 and are expected to grow to nearly $12 billion by 2009. With increased pressure by the SEC and Congress for transparency in reporting where soft dollars are spent, independent research firms are well positioned to track and document research costs. Independent research firms focus on companies and funds generally ignored by large brokerage firms whose focus is generally on large cap stocks.

The use of soft dollars is pervasive by brokerage firms and fund managers and while its practice is legal, there is much concern about just how costly the practice is to investors. Investors aren't fully aware of the practice of soft dollar payments and many are unaware that they are unwittingly paying for the practice through their fund assets. Documented cases of abuse of soft dollar payments are common and as such, more accountability to asset owners (investors) will be forthcoming.

ETF & Index Funds to Lower Costs

Much has been written about the costs that investors have had to shoulder due to inflated trading costs and unscrupulous practices by fund managers. There is some good news for investors who want to fight back and take control of their investment portfolios. Bright spots for investors include the capability to invest in low cost funds that offer significantly reduced trading costs.

Exchange Traded Funds (ETFs) follow index benchmarks like the S&P 500; they also track sectors like energy, financials and health care. Once the investment choice for institutional and retail clients, exchange traded funds are becoming a popular investment option for the individual investor. The ETF is similar to a mutual fund in that it allows an investor to own a fractional share in a portfolio. This ownership of a small piece of a security is similar to ownership in a traditional mutual fund. ETFs are traded on the stock exchange and the value fluctuates during the day. Mutual fund values are based on the value of the fund at market close. Benefits of ETFs include:

• Lower cost to purchase than mutual funds.
• Lower expenses.
• ETFs are an efficient taxable investment; the implications are similar to the sale of stock.

Much of the recent movement to ETFs in the qualified plan marketplace is the result of both the Department of Labor's and the general media's focus on retirement plan expenses. ETFs can typically provide lower costs in the institutional and individual marketplace; however, to achieve the cost savings from the ETF in a 401(k) plan, the provider must determine how to reduce trading commissions to make the low expense ratio become a benefit to participants that is not offset by trading costs (Robertson, 2005).

If the lower expenses proffered by ETF providers are true, the potential savings from ETF offerings in a 401(k) plan can be significant. ETF providers estimate that the savings from an all-ETF platform are as high as one percent of plan assets, depending on the cost ratio of the 401(k) platform. In other words, a plan with $1 million in plan assets could save $10,000 per year. For a participant over 30 years, that one-percent savings could be worth as much as an additional $200,000 or more for retirement (assuming growth at 8 percent per year, $12,000 per year contribution, and $50,000 balance) (Robertson, 2005).

The cost savings related to reducing the ratio expense for a given mutual fund cannot be overstated. The following example further illustrates the impact that mutual fund expenses can have on a stock market that is delivering modest returns.

Conclusion

Trading costs can adversely affect the performance of an investment fund. High turnover of funds adds to brokerage fees and erodes investor assets by eating away at market gains. Individual investors are unaware of many hidden trading costs associated with the management and trading of mutual funds. Fund managers accept soft dollars in return for quid-pro-quo relationships between brokerage houses; while the practice of accepting soft dollars is legal, the SEC is siding with the investor in requiring more disclosure of where soft dollars are spent. There is a growing chorus of criticism regarding the secrecy and obfuscation surrounding trading cost to investors. There's vocal support for much more full and transparent disclosure for the following costs: Brokerage commissions, direct trading costs and soft dollars. Predictions are that funds administrators will work toward more successfully disclosing this information to investors in the future due to increased pressure. Finally, investors are moving away from actively managed funds and the high trading costs associated with them. Investors are including more passively managed funds in their portfolios. Index funds and ETFs are popular choices for investors and more companies are offering these lower cost options to investors along with their more traditional funds offerings. Investors are more aware than ever of the impact that trading costs are having on their individual wealth creation. Individual investors are calling for more accountability from fund administrators and are increasingly unwilling to absorb what they see as unnecessarily high trading costs.

Terms & Concepts

12b-1 Fee: An extra fee charged by some mutual funds to cover promotion, distributions, marketing expenses, and sometimes commissions to brokers. A genuine no-load fund does not have 12b-1 fees, although some funds calling themselves "no-load" do have 12b-1 fees (as do some load funds). 12b-1 fee information is disclosed in a fund's prospectus, is included in the stated expense ratio, and is usually less than 1%.

Bid-Ask Spread (aka Spread): Refers to the difference between the current bid and the current ask (in over-the-counter trading) or offered (in exchange trading) of a given security (Investor Words, 2007).

Brokerage Commissions: Refers to the fee charged by a broker or agent for his/her service in facilitating a transaction, such as the buying or selling securities.

Buy Side: The side of Wall Street comprising the investing institutions such as mutual funds, pension funds and insurance firms that tend to buy large portions of securities for money-management purposes. The buy side is the opposite of the sell-side entities, which provide recommendations for upgrades, downgrades, target prices and opinions to the public market. Together, the buy side and sell side make up both sides of Wall Street.

Exchange Traded Fund: Funds that track indexes and can be traded like stocks at any time during the day. ETFs bundle securities within an index; they never track actively managed mutual funds. A broker is necessary to purchase an ETF and thus a commission fee will be incurred; ETFs have lower transaction fees and operating costs overall making them a better cost investment than a traditional mutual fund.

Expense Ratio: A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual calculation, where a fund's operating expenses are divided by the average dollar value of its assets under management. Operating expenses are taken out of a fund's assets and lower the return to a fund's investors.

Index Fund: An index tracker is a collective investment scheme (usually a mutual fund) that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.

Mutual Funds: A professionally-managed form of collective investments that pool money from many investors and invest it in stocks, bonds, short-term money market instruments, and/or other securities.

Net Asset Value: In the context of mutual funds, the total value of the fund's portfolio less liabilities. The NAV is usually calculated on a daily basis.

Opportunity Costs: The cost of passing up the next best choice when making a decision. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for (Investor Words, 2007).

Portfolio Turnover: The measure of how frequently fund assets are bought and sold; typically for a 12 month period. The measure can be calculated in the following way: (total of new securities purchased) or (total of securities sold) [which ever total is less] / NAV.

Research Services: The process of gathering information about a group of investments. Research supports investment decisions by fund managers, brokers and is often paid for by soft dollars.

Sell Side: The retail brokers and research departments that sell securities and make recommendations for brokerage firms' customers. For example, a sell side analyst works for a brokerage firm and provides research to individual investors.

Transaction Costs: The bundled costs associated with the purchase or sale of an asset. Ex: includes commission cost and bid-ask spread.

Bibliography

Anand, A., Irvine, P., Puckett, A., & Venkataraman, K. (2012). Performance of institutional trading desks: An analysis of persistence in trading costs. Review of Financial Studies, 25, 557-598. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=70438142&site=ehost-live

Bowe, S. (2006). Be aware and be fair: What fiduciaries need to know about plan expenses. Benefits & Compensation Digest, 43, 25-30. Retrieved September 28, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=19450815&site=ehost-live

Bresiger, G. (2007). Soft-dollar bill on the horizon. Traders Magazine, 20, 22-24. Retrieved September 28, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=25939015&site=ehost-live

Damodaran, A. (n.d.). Trading costs and taxes. New York University. Retrieved September 28, 2007, from http://pages.stern.nyu.edu/~adamodar/pdfiles/invphiloh/tradingcosts.pdf

Edelen, R., Evans, R., & Kadlec, G. (2013). Shedding light on "invisible" costs: Trading costs and mutual fund performance. Financial Analysts Journal, 69, 33-44. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85390012&site=ehost-live

Goldberg, S. (2007). Why trading costs so much. Kiplingers.com Retrieved September 28, 2007, from http://www.kiplinger.com/columns/value/archive/2007/va0717.htm

Glover, H. (2006). SEC rule boosts soft-dollar spending. Money Management Executive, 14, 1-15. Retrieved September 28, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21878313&site=ehost-live

Haslem, J. (2006). Assessing mutual fund expenses and transaction costs. Journal of Investing, 15, 52-56. Retrieved October 2, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=22462526&site=ehost-live

Lemoine, A. (2003). Advice — mutual-fund expenses. The Investment FAQ. Retrieved October 1, 2007, from http://invest-faq.com/cbc/adv-mfund-expenses.html

Robertson, J. (2005). Lower costs or hidden problems: The legal concerns for ETFs in 401(k) plans. Journal of Pension Benefits: Issues in Administration, 13, 33-36. Retrieved September 28, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18419831&site=ehost-live

The bid ask spread. (2000). Investor Home. Retrieved September 28, 2007, from http://www.investorhome.com/daytrade/spread.htm

Trading costs. (n.d.). QuickMBA. Retrieved September 28, 2007, from http://www.quickmba.com/finance/invest/tradecost/

Waskik, J. (2007). Soft-dollar, trading costs devour fund returns. Bloomberg. Retrieved September, 28, 2007, from http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist%5fwasik&sid=aPUdYOylNPTE

Wayman, R. (2004). Soft dollars: The good, the bad and the ugly. Research Stock. Retrieved October 1, 2007, from http://www.researchstock.com/cgi-bin/rview.cgi?c=bulls&rsrc=RC-20040128-F

Wherry, R. (2006). Upfront fees, backdoor costs. Smart Money, 15, 28-28. Retrieved October 2, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=22756919&site=ehost-live

What are soft dollars and why should investors be aware of them? Investopedia. Retrieved September 29, 2007, from http://www.investopedia.com/ask/answers/04/011404.asp

Suggested Reading

Hume, L. (2006). NASD fines American funds $5M. Financial Planning, 36, 32-32. Retrieved October 2, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=22895009&site=ehost-live

Robertson, J. (2005). Lower costs or hidden problems: The legal concerns for ETFs in 401(k) plans. Journal of Pension Benefits: Issues in Administration, 13, 33-36. Retrieved September 28, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18419831&site=ehost-live

Soft dollar standards. (2004). Centre for Financial Market Integrity. Retrieved September 30, 2007, from http://www.cfainstitute.org/centre/ethics/softdollar/pdf/SoftDollarStandards2004.pdf