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Higher Returns Thanks to Cost Analysis
Among asset management fees, transaction costs are the least transparent. Choosing the
right broker is of great importance for the cost-effective implementation of any investment
strategy.
Novarca Group
The costs associated with pension
funds and collective foundations are
becoming
increasingly
important.
While coverage has gone up again in
recent
years,
demographic
developments continue to place a
burden on pension funds. In addition,
the
macroeconomic
environment,
characterized by low interest rates and
increasing volatility in capital markets,
is suppressing returns on fixed-interest
investments in particular. The risk of
portfolios – and therefore the prospect
of a potentially better performance –
cannot be increased at will due to
regulatory requirements. Overall, this
is a good thing because more risk
always means more potential losses,
which is not in the best interest of
those insured.
But on the cost side, there is still a lot
of room for improvement. Through
careful analysis of the costs and
renegotiation of the terms alone, 5 to
25 percent of total asset management
costs can be saved – without changing
the
investment
strategy
or
management company. For smaller
pension
funds
and
collective
foundations, these savings quickly add
up to several hundred thousand francs
per year – for large funds, the savings
potential lies in the millions.
KMU-MagazinNr.12,Dezember2015
So where exactly are the highest costs
incurred in asset management? Across
all investment categories, there are
about 150 cost factors, which are
comprised of management costs,
transaction costs and holding costs
(custody). While management costs
constitute the largest cost share (see
the article in KMU Magazine from
October 29, 2015), transaction and
holding costs offer much potential for
savings as well.
Complex Cost Factors
Transaction costs are costs incurred
through the purchase and sale of
securities as part of an investment
strategy. On the one hand, these costs
are generated when the asset
manager buys and sells individual
securities in a portfolio. On the other
hand, transaction costs are generated
by the sale or exchange of an entire
portfolio or entire portfolio elements
due to a change in investment strategy
or because a new asset manager is
selected. Looking at these costs in
more detail is worthwhile.
Just as with management costs and
holding costs, transaction costs consist
of both explicit and implicit costs.
Explicit or hard cost factors, such as
brokerage fees, the subscription fee,
the redemption fee, stamp duty,
fees for market orders (execution only)
and exchange fees, are documented
transparently.
However, implicit costs consist of
hidden charges as well as inefficiencies
and opportunity costs (implementation
shortfalls) that are not fully disclosed.
They are made up of the bid-ask
spreads actually paid, the brokerage
flat rates, the market impact and the
waiting costs. If the portfolio includes
a collective investment scheme,
transparency is additionally limited by
the fact that the transaction costs are
not included in the total expense ratio
(TER), but are incurred depending on
turnover and do not appear in financial
reports.
Non-transparent Influences
The market impact measures the
impact that the purchase or sale of
securities has on the price of the titles
traded. Waiting costs refer to the price
difference between the time of the
investment decision and the time the
order is placed. This time interval may
just be a few minutes, but it can also
be several days, depending on the
procedures
of
the
investment
committee and the actual order. The
opportunity cost is the cost of nonexecution of a transaction in the form
of lost profits.
Overall, this implementation shortfall
has a material impact on the
performance of a portfolio. However, it
is difficult to determine and is
necessarily based on estimates,
making it only prudent to calculate if
an investment strategy involves clear
restrictions on the possible title
selection that go beyond the asset
allocation
of
a
more
general
benchmark.
Measuring the transaction costs is not
easy and should be left to
independent experts. It is not always
clear which cost factors are explicit
and which are implicit, and there is
overlap between the two: If an explicit
commission is charged for one
transaction, it may be implicitly
reflected in the price of an equivalent
transaction. The exact costs can only
be calculated by reviewing each timestamped transaction. Measuring the
transaction costs is therefore mainly a
question of available data.
In addition to minute-by-minute
transaction data, suitable evaluation
tools and data about all involved stock
exchanges and counterparties are
needed to fully assess transaction
costs. Calculating the opportunity
costs of a transaction is further
complicated by qualitative aspects
such as the question of whether the
trader has positioned the order in the
market advantageously – whether he
actively controlled the order before
and during the trading period and
whether the order was placed at a
favourable time.
In some cases, the lack of transparency
around transaction costs is used to
cross-subsidize
the
designated
management fees. This is especially
true if the parent bank of the asset
manager simultaneously serves as the
custodian bank and part of the
securities transactions take place
through the trading department of the
same parent bank.
KMU-MagazinNr.12,Dezember2015
Finances&Provisions
Examples of Explicit and Implicit Transaction Costs
If an investor who conducts business in Swiss francs buys Euros, he must pay a
lower rate than the rate he would receive for the sale of Euros at the same time.
This difference in exchange rate is known as the bid-ask spread. In addition, some
banks charge commissions for foreign exchange transactions.
The commissions are the explicit costs of the transaction; the bid-ask spread makes
up the implicit costs. Banks that demand commissions usually offer the customer a
better exchange rate and a lower bid-ask spread.
Therefore, the investor must take into account the explicit and implicit costs
involved when making price comparisons. The commission-free offer is not always
better for the customer.
Not
Alw ays
Execut ion”
t he
Best
“Best
When
it
comes
to
analysing
transaction costs, the focus should be
on increasing transparency and
changing
the
processes
and
behaviours of asset managers and
brokers.
Market
impact
and
implementation shortfall should be
reduced. However, explicit costs can
be saved as well: There is especially
room for negotiation when it comes to
brokerage fees and defining what
exactly they cover and which services
they entail. In practice, for example,
the transaction costs can be reduced
where a separate transaction fee is
charged in addition to a brokerage
fee. Cost savings of 5 to 30 basis
points of the transaction volume are
possible, which, on average, accounts
for about 5 percent of total asset
management costs – or 20 percent of
the total savings potential.
Overall,
transaction
costs
have
declined in recent years. In fact,
between 2009 and 2014, costs for
share transactions declined by 30 to
50 percent1 due to regulatory changes
in financial market policies such as
MiFID2.
The
repeal
of
fixed
commissions, the disclosure of allinclusive arrangements and the duty of
best execution have made markets
more competitive. These regulatory
requirements
spurred
the
development of new management
models
and
more
efficient
technologies such as algorithmic
trading. Electronic trading systems
have led to lower commissions and
trade margins (spreads) as well as
faster execution. In terms of best
execution, however, there are still
significant
differences
among
providers. This calls for an accurate
measurement and analysis of the costs
so that patterns can be detected and
improved.
Different investments are associated
with varying degrees of transaction
costs. The costs depend on factors
such as the transaction volume, the
market liquidity and the tax regime.
Table 1 shows a greatly simplified
overview of the various asset classes.
__________________
1
Source: ITG Peer Analysis – Global Cost
Review, 2014.
2
MiFID: Markets in Financial Instruments
Directive
Finances&Provisions
Table 1: Transaction Costs of V arious Investment V egicles
Transaction Costs of Various Investment
Vehicles
In Relation to
Transaction Volume
Stock
Europe and USA
Emerging markets
low
low
Bonds
Government bonds of highest credit quality
Investment-grade bonds
High-yield bonds
Emerging markets
low
low
moderate
high
Derivatives (listed)
Spots, Futures
Forwards, Swaps (OTC*)
Hedge Funds
Private Equity
moderate
low
high
high
very high
•
•
•
•
•
•
•
•
Which services are included in the
transaction costs and which are
not?
Are the transaction costs for an
individual portfolio or for the
entire business relationship?
Is the calculation based on the
total volume, average transaction
size or individual transactions?
How
is
best
execution
guaranteed?
How are frequent rearrangements
for the purpose of generating
commissions (churning) avoided?
Is the management fee of the
asset manager applied towards all
transaction costs?
Is the fee a flat fee or a graduated
fee?
In case of flat fees: Are researchrelated fees allocated towards
management costs?
KMU-MagazinNr.12,Dezember2015
Source
Mifid: Markets in Financial Instruments
Directive
Series
What Can Pension Funds Do?
In order to save transaction costs, a
pension fund or collective foundation
must be familiar with its cost structure.
Questions that should be asked
include:
However, cost optimization must be
considered separately from
the
investment decision. The goal of the
cost
analysis
and
subsequent
renegotiation of the terms is not to
find the cheapest investments, but to
implement investment decisions in the
most cost-effective way. Moreover, the
total level of transaction costs must be
considered in relation to the portfolio’s
turnover rate and the underlying
investment strategy.
Part 1: management costs
The choice of broker plays an
important
role
in
optimizing
transaction costs. By analysing brokers
and, respectively, analysing which
asset managers trade through which
brokers in which countries, certain cost
patterns can be revealed and outliers
identified. On average, two out of ten
brokers
are
significantly
more
expensive than their competitors.
An independent cost analysis helps to
clearly assess the status quo, identify
savings opportunities and renegotiate
the fee structure with the appropriate
providers. Since the investment
strategy does not have to be modified
to exploit the savings potential, this
approach results in risk-free additional
returns. In the interest of those
insured, no pension fund should miss
this opportunity.
Part 2: transaction cost s
Part 3: holding costs (cust ody)
About us
We help institutional investors
understand and reduce the costs of all
their investment, both visible and
hidden. We have advised and
analysed over $600 billion of assets
and have built a comprehensive
proprietary database of best practices
and „deals done“. Our clients are
institutional investors such as pension
funds, sovereign wealth funds,
corporates and family offices, with
over $1.5 trillion of combined assets
under management.
Contact
www.novarca.com