Chasing the Same Signals: How Black-Box Trading Influences Stock Markets from Wall Street to Shanghai by Brian R. Brown

Author:Brian R. Brown [Brian R. Brown]
Language: eng
Format: epub
Tags: Personal & Professional Development
Publisher: John Wiley & Sons
Published: 2010-03-14T22:00:00+00:00

THE SIGNIFICANCE OF TRANSACTION COSTS

Fund performance is not only a function of a successful investment strategy, but also a function of its ability to source liquidity efficiently. The mutual fund industry was the first to experience the role of execution: costs are a huge determinant of a fund's performance.

In the 1990s, there was a variety of academic research into one of the less glamorous aspects of asset management: transaction costs. Transaction costs are the friction effects incurred when implementing a fund's investment strategy. These are the costs of brokerage commissions, settlement and clearing fees, taxes, market impact, and opportunity costs. Although they are not as glamorous as research conferences or meetings with CFOs, academic research has highlighted that transaction costs contribute to a fund's performance just as much as successful stock selection.

A study by the Wharton School of Finance, across a random sample of 132 mutual funds, quantified that there is an inverse relationship between a fund's transaction costs and its performance. In its sample period, funds that were in the highest quintile of expense ratios had average returns of 9.76 percent, while funds with the lowest costs had achieved returns of 14.52 percent. The best funds had the lowest transaction costs (see figure 6.3).

Academic research has also shown that fixed costs are only one aspect of transactions. Although larger asset managers will benefit from lower brokerage commissions because of their negotiating power, their size has only limited benefits in reducing their cost structure. As commissions decline, the role of fixed costs becomes less pronounced in market-related costs. The Wharton study showed that average brokerage commissions for the largest U.S. mutual fund managers were in the range of 30 basis points, while transaction costs due to the bid-offer spread were 47 basis points.[31] More than 60 percent of a fund's total costs were market related.

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