When Paul Myners allocated just a couple of pages to the issue of brokerage commissions in his recent report into the UK institutional market, he cannot have anticipated the hornets’ nest he was to disturb. Although he focused on commissions, it has brought the issue of trading costs as a whole into the limelight. On further analysis, the issue of soft commissions, has been completely overshadowed by that of market impact and opportunity cost – costs less tangible than commissions but that dwarf them in magnitude.
Marcus Hooper, head of equity and derivative dealing at Dresdner RCM Global Investors in London, recently demonstrated at a conference in Geneva that trading costs can be colossal. Figures he quoted from Plexus, the California-based transaction measurement company, put the total volume of trades in all markets in the last quarter of 2000 at $1.4trn (E1.56trn). With average execution costs of 174 basis points, the total trading costs for the last quarter were $24.4bn.
Coupled with the findings of a separate piece of research by the Fund Managers Association, it is evident that commissions are the least of pension funds’ concerns. The FMA evaluated typical annual payments for a £200m (e325m) mandate with an annual turnover of 40%. For their purposes they split the cost of managing an equity portfolio into four different categories – the investment management fee; broker commissions; execution costs, and fixed costs such as stamp duty and VAT.
Astonishingly, the research concluded that commissions, the charge highlighted by Myners, accounted for no more than 10% of the total cost of active management. Stamp duty and sundry taxes account for 20% of the total and management fees for 24%, while execution costs and market impact account for almost half the execution costs. Small wonder the issue of commissions has been overshadowed by the other costs, and rightly so.
And this appears to explain why the section dealing with commissions has had such disproportionate publicity. Says a London-based transition manager. “One of the reasons it has become so controversial is that it has gone to the heart of the City, whether it’s the investment banks or the brokers. It was a report on pension funds but the implications of that aspect of the report cut across every aspect of the financial services industry.”
One of the consequences of the report has been to warn investors of the potential costs associated with trading. According to Daniel Wiener, managing director of the securities division for State Street in Europe, what is important for pension funds is that they know exactly what total dealing costs amount to. “There’s no doubt that commissions vary enormously but I think that the important thing is the total cost.” Pension funds therefore need to know the performance of their traders, the performance of their brokers and the difference between the price at which the fund manager wishes to sell and the price at which the trade is executed.
The worst offenders for boosting overall trading costs are likely to be market impact and opportunity cost. Market impact is the adverse effect that your own trading has on the price of a security; opportunity costs refer to the price associated with delaying or prolonging a trade and then paying more for a purchase or selling for less. According to Wiener, the costs are to some extent dependent on the transaction – small trades in large cap liquid stocks are unlikely to incur any market impact, vice versa with large trades in illiquid stocks.
In practice the two tend to be inversely proportional and there exists a trade-off between the two. For argument’s sake, say a fund wants to execute a large order. Putting it through in one or a handful of orders is likely to push the price up – incur market impact. Spreading out the purchase reduces market impact but the manager runs the risk that the price will rise anyway – opportunity cost.
One system touted as alleviating market impact is crossing, supplied by the likes of E-Crossnet and ITG’s POSIT. Crossing can be extremely efficient and testimony to this is the popularity of networks in the US. It’s a process that has its doubters, who say those trades that cross are more likely to be in large volume stocks that would otherwise have been relatively easy to trade with minimal market impact. Nevertheless, transition managers do cross and it can be highly effective. Wiener says it needs to be used intelligently though and it is essential not to lose sight of the potential opportunity cost of waiting patiently for a match.
In reality, managers only cross a limited portion of their portfolios and instead have to minimise the consequences of market impact and opportunity cost. Rick Boomgaardt, the ex-Goldmans man now running transition management at Credit Suisse First Boston in London, says a precise calculation of the trade-off is tricky. Clearly, as market impact increases, so opportunity cost falls, and vice versa, but the exact trade-off is hard to measure in isolation.
Instead, the two need to be taken together. There are proxies for market impact – namely the deviation
of the execution from the volume-weighted average price (VWAP). Recently, this measure has slightly fallen from grace as being less than perfect.
Boomgaardt explains: “If you’re putting a lot of size through on a single trade, you’re going to be a significant chunk of the volume. So the fact that you’re on VWAP doesn’t really show how much you’ve impacted the market because you’re going to be the volume. It can be a meaningful number assuming you’re a fairly small percentage of the daily volume.”
Other means of measuring transaction costs are provided by US-based companies including Plexus, Elkins McSherry, BECS and Abel Noser. In the UK, the WM Company has recently begun marketing its Trading Cost Analysis that serves to analyse the effectiveness of a pension fund’s trading. According to Peter Warrington, the analysis looks at three elements – commissions, legal costs and market impact.
WM has already registered 16 clients including pension funds and charity foundations. Other clients include one of the German liberal profession funds that looks after architects, doctors and so on. WM says it is receiving considerable interest from Dutch funds eager to analyse their trading costs.
But nowhere is measuring transaction costs more important than transition management, where turnover in a fortnight can equal that of an average couple of years. Here market impact, opportunity costs and fixed costs combine with such intensity that any slippage can lead to severe costs. “You haven’t got to have that significant a tracking error between the old and the new portfolio to generate a huge potential opportunity cost,” says Wiener.
The problem with trying to measure and to compare the cost and performance of transition management is simple, there is no standard yardstick at present. Rick Di Mascio’s Inalytics (see box) provides measurement using implementation cost, the sum of fixed costs, market impact and opportunity costs. Di Mascio says they have had some success in convincing transition managers the best way to measure themselves is via implementation shortfall rather than VWAP. Now this has been achieved, all that remains is to mastermind a common definition for implementation shortfall.
Then there are those costs that are impossible to avoid. Leading the pack are stamp duties in Ireland and the UK, which stand at a punitive 100 and 50 basis points respectively. As one manager out it: “It’s ironic that although Paul Myners concentrated on commissions, one of the most expensive parts of a UK pension fund transition is the stamp duty, which can run to five times commission.”
These two remain the only two cross-border taxes in Europe; some funds are charged for trades within their own market. Such taxes are highly lucrative – each year the UK Treasury pockets £4bn in stamp duty alone – meaning it will take a brave Chancellor to abolish it. Says Wiener: “I appreciate the political implications of getting rid of stamp duty but it’s not a tax on the rich, it’s a tax on any beneficiary of any pension fund that invests in UK equities and it’s not appropriate in a modern and developed market.”
In contrast to this anachronism, Europe has put together some great trading platforms. A common assumption is that it is cheaper across the board to trade in the US than in Europe.
In terms of the implicit costs, they are probably no more in Europe than they are in the US. Many European Bourses have proved themselves to be efficient trading structures – market impact, opportunity cost and spread look relatively attractive. What Europe lacks is a central counterparty and this makes the back end of the business expensive. “Oddly enough, Europe has done better in getting its exchange structures right in terms
of the way that the markets operate but it has not been very good at getting the clearing structure right. Whereas in the US things haven’t advanced so much on the trading side, the settlement is extremely
efficient,” says Wiener.
Myners’ report has brought to the fore issues vital to institutional investors. Di Mascio believes that in addressing commissions Myners and the Treasury have opened a Pandora’s box.
“Although the Myners report was relatively narrow in its focus, all these other costs have popped up as well, and quite rightly. I think that all this debate at the moment about transaction costs and transaction cost measurement is entirely healthy because funds are incurring these costs and it’s appropriate and right that they are getting on top of this,” he says.
Those involved in transition management or transaction analysis admit they are in a growth industry. As one in the business put it succinctly, if not a shade smugly, “We could not have wished to come into the business at a better time. I feel we ought to be paying a commission to Paul Myners himself.”

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