Trading Cost

The cost associated with trading securities can have a non-negligible impact on portfolio return. Trading costs include the following:

• Explicit costs - commissions, fees, and taxes.

• Market maker spread - difference between the bid and ask prices that the specialist sets for a stock; the specialist keeps the difference as compensation for providing immediacy. For less liquid stocks, the specialist has greater exposure to adverse price movements and likely will make the spread larger.

• Market impact - results when high volume trades influence the market price. Market impact can be broken into two components - a temporary one and a permanent one. The temporary component is due to the need for liquidity to fill the order. The permanent impact is due to the change in the market's perception of the security as a result of the block trade.

• Opportunity cost - the effective cost of price movements that occur before the trade executes.

NYSE specialists sometimes may appear to have a monopoly on trading their respective securities, creating a larger than necessary spread between bid and ask. However, there is more competition than is initially obvious. First, there is competition for the specialist positions, providing the specialist incentive to price fairly. Furthermore, there are other specialists on the floor who may be willing to trade within the spread if it is too wide.

The total trading cost of a buy transaction is calculated by taking the percentage increase of the average purchase price as compared to the price when the buy decision was made, and adding the commissions, fees, and taxes as a percentage of the price when the buy decision was made.

Active portfolio managers attempt to outperform passive benchmarks, but trading costs reduce any realized advantages. Typical trading commissions run 0.20% of the transaction amount, and the typical cost due to bid-ask spread and market impact is 0.55%. The total cost of a trade then is 0.75% of the trade amount. If a fund has a portfolio turnover rate of 80%, and for every sell transaction the stock is replaced via a buy transaction, a total of 160% of the portfolio value will be transacted each year. For trading costs of 0.75% per transaction, the annual trading costs amount to (1.6)(0.75%) = 1.20% of the portfolio value. If one adds a 0.3% management fee to this amount, the total becomes 1.50%.

Reducing Trading Costs: Passively Traded Funds

Passive portfolios have lower transaction costs and overall trading costs. The transaction cost is typically 0.25% of the transaction value, since a passive portfolio does not have to trade as quickly and can be more patient with each transaction. A typical turnover rate for a passive portfolio is about 4% per year, and assuming replacement 8% of the portfolio value will be transacted each year for annual trading costs of only (0.08)(0.25%) = 0.02% of the portfolio value. Passive portfolios have lower management fees, for example, 0.10%, so the total of trading costs and management fees is only 0.12%, compared to 1.50% for a typical actively managed fund.

Passively managed funds that track an index often have returns less than that of the index because of trading costs, especially for small-cap indices in which the securities are less liquid. These trading costs can be reduced if the weights of the securities in the fund are allowed to deviate somewhat from the index, since both trading volume and the need for immediacy are reduced. The correlation with the index still can remain quite high under the relaxed weights.

In 1982 Dimensional Fund Advisors (DFA) introduced a passive small-cap "9-10" fund composed of the lower two deciles of NYSE market capitalization. The fund sacrificed tracking accuracy by allowing the weights to deviate in order to minimize trading costs. The result was higher performance than other small-cap funds. The 9-10 fund even outperformed the stocks in the lower two market capitalization deciles of the NYSE, partly due to the following strategies:

1. The 8^th decile is treated as a hold range, not a sell range,

2. The DFA waits a minimum of one year before buying IPO's,

3. The fund does not buy stocks selling for less than $2 or having less than $10 million in market capitalization,

4. The fund does not buy NASDAQ stocks having fewer than four market makers,

5. The fund does not buy bankrupt stocks, and

6. The fund is passive, not rigidly indexed.

Note that using the 8^th decile as a hold range effectively increases the average market cap of the portfolio and increases returns in periods in which large caps outperform small caps, such as in the 1980's.

Reducing Trading Costs: Electronic Trading

Electronic crossing networks have lower trading costs than do exchanges because of lower commissions, no bid-ask spread, and elimination of market impact. By matching the natural buyers and sellers of a security at some predetermined price, for example, the NYSE closing price, electronic crossing networks eliminate the need for a market maker to provide liquidity. However, crossing networks require buyers and sellers to participate in order for there to be liquidity. Furthermore, there are the disadvantages of potentially limited liquidity and no inherent price discovery mechanism.

Electronic communications networks are computerized bulletin boards for matching trades. Because the traders can remain anonymous, price impact is diminished.

Another electronic trading mechanism is the single-price call auction in which buyers and sellers simply place limit orders. The market clearing price is set at the intersection of the supply and demand curves.

Recommended Reading

Gregory Baer and Gary Gensler, The Great Mutual Fund Trap : An Investment Recovery Plan