Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 256

5 red flags on active manager trading costs

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.

banner

Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Now you can earn 5% on bonds but stay with quality

Conservative investors who want the greater capital security of bonds can now lock in 5% but they should stay at the higher end of credit quality. Rises in rates and defaults mean it's not as easy as it looks.

30 ETFs in one ecosystem but is there a favourite?

In the last decade, ETFs have become a mainstay of many portfolios, with broad market access to most asset types, as well as a wide array of sectors and themes. Is there a favourite of a CEO who oversees 30 funds?

Welcome to Firstlinks Election Edition 458

At around 10.30pm on Saturday night, Scott Morrison called Anthony Albanese to concede defeat in the 2022 election. As voting continued the next day, it became likely that Labor would reach the magic number of 76 seats to form a majority government.   

  • 19 May 2022

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Latest Updates

Superannuation

'It’s your money' schemes transfer super from young to old

With the Coalition losing the 2022 election, its policy to allow young people to access super goes back on the shelf. But lowering the downsizer age to 55 was supported by Labor. Check the merits of both policies.

Investment strategies

Rising recession risk and what it means for your portfolio

In this environment, safe-haven assets like Government bonds act as a diversifier given the uncorrelated nature to equities during periods of risk-off, while offering a yield above term deposit rates.

Investment strategies

‘Multidiscipline’: the secret of Bezos' and Buffett’s wild success

A key attribute of great investors is the ability to abstract away the specifics of a particular domain, leaving only the important underlying principles upon which great investments can be made.

Superannuation

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Shares

Confession season is upon us: What’s next for equity markets

Companies tend to pre-position weak results ahead of 30 June, leading to earnings downgrades. The next two months will be critical for investors as a shift from ‘great expectations’ to ‘clear explanations’ gets underway.

Economy

Australia, the Lucky Country again?

We may have been extremely unlucky with the unforgiving weather plaguing the East Coast of Australia this year. However, on the economic front we are by many measures in a strong position relative to the rest of the world.

Exchange traded products

LIC discounts widening with the market sell-off

Discounts on LICs and LITs vary with market conditions, and many prominent managers have seen the value of their assets fall as well as discount widen. There may be opportunities for gains if discounts narrow.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.