It has long been known that transaction costs eat into trading profits, with Benjamin Graham dedicating vast swathes of his magnum opus, The Intelligent Investor, to this phenomenon as far back as the 1960s. However, they do not just do that, lower transaction costs are actually linked to higher gross performance, i.e., before the costs are factored into the mix. Although the causes of this are up for debate, the correlation is unambiguous.
Through ClearGlass Research Analyst Reports, it is already known that higher management fees are negatively correlated with higher performance in global active equities (link to article). But what about transaction costs? These are split largely into two types, explicit and implicit. Explicit fees are those charged directly to the client, such as broker fees, taxes and exchange charges. Implicit fees are less observable, formed by a combination of the ‘slippage’ between the price and order placed and the average price it was settled at, the bid-ask spread offered by the market maker and the impact of the trade on the market value, through liquidity.
The table below is taken from the ClearGlass Global Active Equities Analyst Report. It shows that when asset managers are sifted into quartiles based on performance, the worse-performing managers generally record the highest implicit and explicit transaction costs. The correlation is clear and the causal links could be numerous, such as poor execution, over-trading or inefficient trading infrastructure. What is not ambiguous is that the managers with the most conservative and efficient trading strategies have generally superior performance, which, when coupled with lower average ongoing charges, leads to significantly better value for money for asset owners.
The natural rebuttal to this conclusion would be that transaction costs are subject to change year-to-year and therefore funds with poor performance in a single year may be disadvantaged by equally poor trading performance in that year. However, through the study of the variances in transaction costs year-on-year, these have been shown to be minimal. The variance of a fund’s transaction costs over time was limited – so ex-ante transaction costs are likely to be accurate. This may be seen in the table below, where, somewhat surprisingly, transaction costs have a lower variance than ongoing charges.
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This article was informed by the ClearGlass Global Active Equities Analyst Report, which you may access here: https://clearglass.com/research/#ResearchArticles