Controlling trading costs is complex because trading takes time, the demand for securities and other assets are not perfectly elastic, and the price impact of trades can affect the course of future prices.
Return on Active Management = Expected Return +Return from Tactical/Opportunistic Trading – Trading Costs
Active portfolio management attempts to outperform broad market indices and passive strategies, but the costs associated with trading and transactions have negative impact on the total returns and hence diminish the potential benefits of active management.
The types of trading costs can be categorized into explicit costs and implicit costs.
Explicit costs represent the direct, clear, and obvious cash outflows that arise during transactions:
- Broker commission costs are the service charges by an agent or an agent’s company to facilitate buys and sells. Broker commission costs are perhaps the most explicit costs that investors pays.
- Taxes. According to the most recent tax law, a trader’s expenses are deductible on Schedule C in determining adjusted gross income. In contrast, an investor’s expenses are only deductible as other miscellaneous itemized deductions under Section 212 and subject to a 2 percent of adjusted gross income floor.
- Stamp duty is the tax placed on the transfer of securities.
- Fees paid to the exchanges.
Implicit costs refer to indirect trading costs:
- Bid-ask spread is the difference between the highest price at which an investor is willing to pay for an asset and the lowest price at which an investor is willing to sell at the same point in time. Bid-ask spread is determined by supply and demand, or liquidity, ownership structure, price level, information transparency, and corporate governance of the asset.
- Price impact is created during the trading on an asset, pushing the price up when an investor buys the asset and pushing it down while he or she sells it. There is price impact inherent in any trade because large trades almost always attract the attention of other investors in the same assets, more importantly, markets are not fully liquid.
- Missed trade opportunity costs or opportunity costs arise from the failure to execute a trade in a timely manner, and the inability to complete the desired trade immediately due to its size and the liquidity of markets.
Implicit costs are sensitive to market conditions and information asymmetry. Most traders measure implicit costs with reference to some price benchmark or reference point. Measures of implicit trading costs can be broadly classified into pre-trade, during trade, and post-trade measures, depending on the benchmark prices used. Trading professionals typically use the time-of-trade midquote to calculate the effective spread.
Trading Costs of Alternative Investments
Alternative asset classes have different ranges of standard trading costs and fees from those of traditional equities.
- Commodities: The transaction costs that are associated with commodities such as gold and silver are perhaps the smallest, since they tend to come in standardized units. The transaction costs may be impacted by the costs of searching for and suitable suppliers, the problems with lack of performance due to incomplete specification of contracts, and the failure of contractors to perform a contract. Therefore, the transaction costs of commodities increase with volatility.
- Fine Art and Collectibles: The commissions of fine art or collectibles are much higher. On one hand, there are fewer intermediaries in this business; on the other, fine art and collectibles are not standardized. Transaction costs are relatively objective since they are less frequently traded. The funds that invest in fine art and collectibles typically charge a two-percent annual expenses which include storage, maintenance, insurance and transactions, an a 20 percent of profits that investors pay to fund managers.
- Private Equity: The trading costs of private equity are largely affected by the liquidity of each asset, the financial health and cash flows of the holding firm, the exit option in the future, and the size of the firm. A study covering a vast majority of the transactions from 2009 to 2010 shows that the median transaction fees regardless of deal size is approximately 1.1 percent.
- Real Estate: In residential real estate, the commission that investors pay to a broker is typically 5-6 percent of the total value of the property, whereas in commercial real estate, the commission may be smaller, especially for larger transactions.
How to Control Trading Costs
- Develop a coherent investment philosophy, a long-term-oriented investment strategy, and stay within a portfolio size that is consistent with the investment philosophy and the selected trading strategy.
- Estimate the opportunity costs given each respective investment strategy, and take advantage of the alternative options available on the exchange floor to minimize transaction costs.
- Constantly monitor the portfolio and consider whether the investment strategy is yielding returns that exceeds the costs.
Pre-trade measures use prices prior to the trade, usually the prior day’s close. The theory of market microstructure suggests that trading costs are systematically related to certain factors, including: stock liquidity characteristics, risk, trade size relative to available liquidity, momentum, trading style.
With these factors and the necessary calculations, investors can use regression analysis and nonlinear methods to estimate the relation between costs and these variables. The main objective of pre-trade analysis is to form an estimate of the cost of trading as to help the portfolio managers gauge the correct trade size to order in the first place.
Implementation Shortfall and Electronic Trading
Implementation shortfall is defined as the difference between the money return or value when a decision to trade is made and the final execution price after adjusting all commissions, fees, and taxes. If investors aim to keep implementation shortfall as low as possible in order to realize a high profit potential.
Electronic trading, also called etrading, was launched fully in 1992. Electronic communications networks are computerized bulletin boards for matching trades. Over the two decades, both buy-side and sell-side investment firms have been increasing spending on the technology for electronic trading.
Because the traders can remain anonymous, price impact or market impact is minimized. In addition, electronic crossing networks have lower trading costs than do floor trading because of lower commissions and no big-ask spread. Furthermore, by matching the natural buyers and seller of a security at a predetermined price, electronic trading also eliminates the need for a market maker to provide liquidity, although there are disadvantages of no inherent price discovery mechanism. The development of implementation shortfall and electronic trading has greatly improved the efficiency of trading costs.
Pretrade Analysis: Econometric Models for Costs, World Finance, May 2011
 Measures of Implicit Trading Costs and Buy-Sell Asymmetry by Gang Hu March 2009
 Economic Theory, Applications and Issues by Clem Tisdell August 2003
 Transaction and Monitoring Fees: On the Rebound? A Joint Investigation by Dechert and Preqin.
 Trading Costs and Taxes by Aswath Damodaran at NYU Stern School of Business
 Market microstructure is a branch of finance concerned with the details of how exchange occurs in markets. Maureen O’Hara defines market microstructure as “the study of the process and outcomes of exchange assets under a specific set of rules. Microstructure theory focuses on how specific trading mechanisms affect the price formation process. Definition by Wikipedia.