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Finances&Provisions PensionFinancing,Part2/3 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