Many active managers turnover shares in their portfolios regularly as they seek to outperform. This activity might be to lock in a gain, reduce or prevent a loss, manage portfolio risks, reinvest dividends or manage liquidity. Trading is a ‘bread and butter’ activity in any active equity portfolio which must keep churning to keep its insights current.
It is surprising, then, that the science – or perhaps art – of trading efficiency is something of a ‘black box’ inside equity portfolios. There are explicit costs of trading equities – brokerage and commissions (and transaction taxes in some countries) – as well as implicit costs of buy-sell spreads and price impacts (also called moving the market, meaning pushing the market price higher as a fund buys into it or lower as the fund sells out of it). Institutional investors with large equity portfolios should care about this ‘black box’ because whether a manager trades efficiently or inefficiently can materially affect net returns. Retail investors also feel the impact via a decision to choose active.
The baseline costs of ‘patient’ trading
To test how returns are affected by such costs, we simulated a range of institutional-size portfolios across Australian and international equity markets. We used as a baseline trading efficiency measure passive (market cap weighted) portfolios in S&P/ASX200 and MSCI World ex-Australia equities which used an execution-only (agency execution) arrangement and adopted a patient trading style. The baseline portfolio trades were a $100 million slice in Australian equities, representing 2.4% of the market’s liquidity (median daily volume) and a $500 million slice in international equities, representing 0.2% of the market’s liquidity.
A fund trading this kind of baseline portfolio could expect to pay about 0.21% of the total value of the Australian equity trades in trading costs, being 0.05% in explicit costs and 0.16% in implicit costs. For international equity trades, it could expect to pay 0.11% of total trade value in transaction costs, being 0.05% in explicit costs and 0.06% in implicit costs. These baseline results are encouraging and, for most funds, probably don’t create much of a hurdle for the trades to add value to the portfolio post-trading costs.
In considering different kinds of portfolios and trading approaches, here are five ‘red flags’ to watch for:
1. Trading on a principal, rather than agency, basis increases trading costs
Most equity trading, especially in Australia, is not agency based. In principal-based trading, the fund investor or manager is legally transacting with a broker who takes the equities onto the broker’s own books and requires additional compensation for assuming this risk. The broker often bundles additional non-execution services into the commissions charged, which in Australia can easily be three times as much as an execution-only commission rate. Are these additional costs worth paying? Perhaps, but because the costs are embedded in brokerage charges on trades inside portfolios, the fund investor rarely considers this question.
2. As portfolio trade sizes get larger, trading becomes costlier
Our baseline cost of trading Australian equities, 0.21%, almost doubles to 0.38% for a $500 million passive portfolio trade and reaches 0.48% for a $1 billion passive trade slice. Our baseline passive international equity trading cost, 0.11%, rises to 0.13%-0.26% when the trade size increases to $1 billion - $5 billion. These trade sizes are not unrealistic when you consider that the capital managed by superannuation funds collectively has now reached $2.6 trillion and APRA-regulated funds, whose portfolios are being rationalised, invest an average 51.5% of their capital (close to $900 billion in total) in Australian and international equities.
3. Active portfolios are costlier to trade than passive portfolios
Active portfolio trades typically demand more liquidity than passive portfolios. We modelled two types of active Australian equity portfolios which, compared to our baseline passive trade, demanded between 12.7%-62.9% of market liquidity for the same-sized trade. This pushed the total cost of the trade up from 0.21% to 0.37%-0.66%. Our hypothetical active international equity portfolios demanded 1.2%-3.4% of market liquidity, which pushed trade costs up from our 0.11% baseline to 0.19%-0.25%.
4. Australian equities are costlier to trade than global equities
Explicit costs to trade in Australia are relatively high by global developed-market standards, and it is not clear why. Implicit costs are also higher because the Australian equity market is roughly one-fortieth of the size of global developed equity markets, so it is easier to adversely move the market.
Superannuation funds and other large investors tend to show a ‘home bias’ towards Australian equities and support active rather than passive management. They are favouring an asset class and investment style that is more expensive to trade. Further, the redundant trading that occurs in multi-manager equity structures (absent centralised implementation) is particularly a problem in Australian equities where there is potential for different managers to trade against each other, to no net benefit in the overall portfolio.
5. Aggressive trading styles significantly increase trading costs
Finally, an equity manager’s view on how quickly, or urgently, to ‘work the trade’ in the market significantly affects trading costs. In our best-case scenario (international equities, passive, smaller trade size), a very aggressive trading style increased trading costs to 0.16% by almost doubling the implicit cost of passively trading the same order. In our worst-case scenario (Australian equities, active, large), a very aggressive trade pushed up transaction costs from an already concerning 0.66% (patient trading style) to 1.24%.
Considerations for investors
Large investors who recognise their own ‘red flags’ in these scenarios should also remember that most trades are ‘round trip’ – selling one stock, buying another – which doubles the trading cost impacts we have identified. The cumulative impact of these higher transaction costs, with the higher taxes and higher fees that come with active management, creates a hurdle that for some equity managers may be just too high to clear.
Raewyn Williams is Managing Director of Research at Parametric Australia, a US-based investment advisor. This information is intended for wholesale use only and does not consider the circumstances of any investor. Additional information is available at parametricportfolio.com.au.