The Cost of Trading: Seeing the Full Picture

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There have been numerous academic studies examining the relationship between the cost of investing and its subsequent impact on performance. In general, cost and performance have a significant negative relationship, which makes sense at a very practical level. In the highly efficient capital markets, incurring more cost, on average, increases the probability of underperforming a certain benchmark relative to others. But the costs associated with investing are very inconspicuous, and although investors vet characteristics such as expense ratio, turnover, or load fees when deciding how to invest, these characteristics do not fully capture the actual cost of investing.

A paper recently published in the Financial Analysts Journal1 aimed at pinpointing the exact culprit by delving further into a more "invisible" cost – trading. Using portfolio holdings and transaction data, the authors concluded that "sorting funds by expenses, fund total net assets, or turnover yields no consistent pattern of returns. In stark contrast, sorting funds on the basis of their aggregate trading-cost estimate yields a clear monotonic pattern of decreasing risk-adjusted performance as fund trading costs increase."

Traditionally, many industry professionals have looked at annual turnover, the percentage of assets that changed over the course of the year, in order to proxy the cost of trading, but examining turnover alone does not accurately reflect nor explain mutual fund underperformance relative to their peers – mainly because it does not take into account the per unit cost of trading. Other things to consider include trading volume, brokerage commissions, bid-ask spread, and price impact. The table below, taken from the research paper, shows trading cost data among different asset classes as well as average expense ratios. The chart below displays the aggregate trading cost and expense ratio for multiple asset classes.

Descriptive Statistics for 1,758 U.S. Domestic Equity Mutual Funds
12 Years(1/1/1995 to 12/31/2006)
  Average Turnover Average Total Trading Cost Average Expense Ratio Total Expense Ratio Plus Trading Cost
All Funds 82.4% 1.44% 1.19% 2.63%
Small Cap Value 58.1% 2.29% 1.28% 3.57%
Small Cap Blend 71.8% 2.32% 1.20% 3.52%
Small Cap Growth 118.5% 3.17% 1.39% 4.56%
Large Cap Value 65.2% 0.84% 1.07% 1.91%
Large Cap Blend 52.2% 0.61% 0.98% 1.59%
Large Cap Growth 89.3% 0.97% 1.23% 2.20%

The mean aggregate trading cost amongst all US Domestic equity funds analyzed was 1.44%. In other words, investors lost $1.44 for every $100 invested just from trading alone. This of course is on top of the 1.19% mean expense ratio that investment managers take every year.

Also notice that price impact was the most expensive component of the per unit cost of trading – averaging 65% of the entire per unit cost. Price impact refers to the cost of suddenly increasing the supply or demand for a particular security. As we move into the small capitalization market, these costs become quite significant – averaging 2.59% in aggregate trading costs. Interestingly, the expense ratios, trading volume, and annual turnover percentage of the mutual funds among the asset classes presented are around the same magnitude (small cap growth seems to be the only outlier). The chart below displays the aggregate trading cost and expense ratio for multiple asset classes. Notice how similar the expense ratios are versus the obvious difference between trading costs for small cap stocks and large cap stocks.

Practical application of these findings suggests that professional money managers can add value to their clients' portfolios by trying to mitigate these so-called frictions of trading, especially in corners of the market where investors are expected to be rewarded (small cap and value). Not only is it important to trade infrequently, but to also make a minimal amount of impact on the market when moving large positions. Passively managed portfolios address the first issue, but not necessarily the second.

IFA advises utilizing funds from Dimensional Fund Advisors (DFA) given their commitment to address the cost of price impact. By not constraining themselves to tracking a commercialized index, DFA adds value to a clients portfolio by focusing on constant exposure to the asset class without incurring unnecessary costs when commercialized indexes reconstitute themselves – forcing many traditional index funds to move large positions in a matter of days. By constantly rebalancing their portfolios in small pieces, DFA minimizes their price impact. Historical performance supports DFA's approach.

The chart below shows the 10 year annualized returns ending December 31, 2012 for the DFA Large Cap Value, DFA Small Cap Value, Vanguard Value, and Vanguard Small Cap Value funds, as well as the averages for all mutual funds of the same category in the Morningstar universe.

The first thing to notice is that among both the large cap value and small cap value asset classes, DFA outperformed Vanguard by a significant amount over this period, even with a slightly higher management fee. This is important since it isolates the effects that trading costs can have on portfolio performance, even after considering the fund's expense ratio. Second, following a passive strategy that had both low management fees and low trading costs (DFA) led to significant outperformance compared to the entire Morningstar universe among both asset classes.

As an independent investment advisor, IFA is committed to finding the best investment options for our clients. Keeping costs low, both visible and invisible, is one of the cornerstones of the passive investing philosophy. When vetting different fund families, management expenses are not the only item considered when deciding which strategies to implement in our index portfolios. Trading costs can have a significant impact on total performance, even among different types of index funds.

Regardless of whether investors use Vanguard, iShares, DFA, or any other type of index fund, keeping trading activity low and spread out will complement low management fees well.

Think of a portfolio as a bar of soap. The more frequently you decide to mess with it, the less of it you will have.

1 Edelen, Roger, Richard Evans & Gregory Kadlec. "Shedding Light on ‘Invisible' Costs: Trading Costs and Mutual Fund Performance." Financial Analysts Journal: Vol. 69, No. 1, 2013