Shedding Light on Invisible Costs:Trading Costs& Performance

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Shedding Light on Invisible Costs:Trading Costs& Performance

Postby grok87 » Thu Feb 14, 2013 1:56 pm

This months Financial Analysts Journal (FAJ) has a good article on the hidden cost of mutual fund turnover/trading. Here is the abstract

Shedding Light on Invisible Costs:Trading Costs& Performance
By Edelen, Evans and Kadlec

http://www.cfainstitute.org/learning/pr ... .n1.6.aspx
Abstract
Industry observers have long warned of the “invisible” costs of fund trading, yet evidence that these costs matter is mixed because many studies do not account for the largest trading-cost component—price impact. Using portfolio holdings and transaction data, the authors found that funds’ annual trading costs are, on average, higher than their expense ratio and negatively affect performance. They also developed an accurate but computationally simple trading-cost proxy—position-adjusted turnover.

Here are some of the stats:

Segment............... Stated Expense Ratio..Average Turnover.........Cost of Turnover/Trading*......cost per 100% of turnover
All Funds............................1.19%................82%....................1.44%..................................1.76%
Small Cap Growth..................1.39%..............119%....................3.17%...................................2.66%
Small Cap Blend....................1.20%................72%....................2.32%..................................3.22%
Mid Cap Blend......................1.22%................71%....................1.44%..................................2.03%
Large Cap Blend....................0.98%................52%....................0.61%..................................1.17%

*i.e. hidden additional expense ratio

The stated expense ratio column shows the average stated expense ratio for the different fund categories, as per the prospectus. The average turnover is also stated in the prospectus. The cost of turnover/trading is the authors' estimate based on the methodology in the paper- this is the "hidden" expense ratio that must be added to the stated expense ratio to get to the true cost of owning the fund. Their basic point is that this is often greater than the stated expense ratio.

The final column is the ratio of the two proceeding columns. This is meant to be helpful for a specific fund that one might be interested in. For example if you know that a midcap fund has average turnover of 50%, then one would estimate the hidden expense ratio from trading costs at 1.015% (=50%*2.03%).

Small cap growth funds had the worst turnover and highest trading costs (aka hidden expense ratio).

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trading costs and taxes

Postby Taylor Larimore » Thu Feb 14, 2013 2:38 pm

Grok:

Thank you for bringing our attention to this important article. I am unable to read the entire report (without paying a fee). Does the article include capital-gain taxes as a trading cost ?

Best wishes.
Taylor
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby Rodc » Thu Feb 14, 2013 3:00 pm

For an index fund it would seem very easy to compute/estimate trading costs: Index return - fund return.

I wonder if it would have the same cost per 100% as shown here for some of the common index fund.
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Total Index Costs

Postby EDN » Thu Feb 14, 2013 3:18 pm

Rodc wrote:For an index fund it would seem very easy to compute/estimate trading costs: Index return - fund return.

I wonder if it would have the same cost per 100% as shown here for some of the common index fund.


Rodc,

But the index return doesn't account for the market impact of reconstitution. Its really a catch 22--some indexes, like Russell, try to avoid excessive trading that results from updating their indexes too frequently by doing a major annual reconstitution. Unfortunately, these changes are front-run and prices are bid up/down prior to their addition or deletion from the index. This wouldn't show up in the raw index return, but does appear when the index's return is well below its expected return based on exposure to risk factors. So IWM may track the Russell 2000 very closely, but the index itself may trail a similar small cap index (say the S&P 600 Index) by 200bps per year. This is because of the inherent trading costs that occur prior to the index funds actually trading.

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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby dumbmoney » Thu Feb 14, 2013 4:05 pm

Rodc wrote:For an index fund it would seem very easy to compute/estimate trading costs: Index return - fund return.


That doesn't capture trading costs due to index changes. Since index changes are announced in advance, the trading of index funds affects the index return.

The bottom line question is: does the trade add to return or subtract? Clearly a fund that trades randomly would be better off not trading, since any trading cost would directly subtract from return. Not sure that random trading is the best model of fund behavior.
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Low trading costs.

Postby Taylor Larimore » Thu Feb 14, 2013 4:12 pm

Bogleheads:

One seldom mentioned advantage of total stock market index funds is their low turnover--and low hidden costs.

Vanguard's Total Stock Market Index Fund annual turnover is 5%.
Vanguard's Total International Index Fund annual turnover is 3%

Best wishes.
Taylor
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby Random Musings » Thu Feb 14, 2013 5:11 pm

The report seems to say, that at least for small and mid cap funds, the average alpha hurdle is from 260 to 460 basis points. :shock:

If that's the case, the average active fund is even better than I thought it was in terms of picking stocks.

However, costs really matter, and they do fail.

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Re: Total Index Costs

Postby Rodc » Thu Feb 14, 2013 5:25 pm

EDN wrote:
Rodc wrote:For an index fund it would seem very easy to compute/estimate trading costs: Index return - fund return.

I wonder if it would have the same cost per 100% as shown here for some of the common index fund.


Rodc,

But the index return doesn't account for the market impact of reconstitution. Its really a catch 22--some indexes, like Russell, try to avoid excessive trading that results from updating their indexes too frequently by doing a major annual reconstitution. Unfortunately, these changes are front-run and prices are bid up/down prior to their addition or deletion from the index. This wouldn't show up in the raw index return, but does appear when the index's return is well below its expected return based on exposure to risk factors. So IWM may track the Russell 2000 very closely, but the index itself may trail a similar small cap index (say the S&P 600 Index) by 200bps per year. This is because of the inherent trading costs that occur prior to the index funds actually trading.

Eric


That is a complication.
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Re: Low trading costs.

Postby Rodc » Thu Feb 14, 2013 5:27 pm

Taylor Larimore wrote:Bogleheads:

One seldom mentioned advantage of total stock market index funds is their low turnover--and low hidden costs.

Vanguard's Total Stock Market Index Fund annual turnover is 5%.
Vanguard's Total International Index Fund annual turnover is 3%

Best wishes.
Taylor


Indeed that may be its main advantage, low trading costs and low tax hit (if in taxable).

I'm not sure I buy the "optimal diversification" arguments, but can't argue with these real world benefits.

Rod
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby Random Walker » Thu Feb 14, 2013 5:36 pm

In the DFA versus VG debate, we usually cite the ER difference between the funds and the AUM fees of the advisor. I'm guessing that since DFA doesn't have to mirror an external index and engages in patient trading that this difference narrows the overall expense difference between VG and DFA. Is the difference enough to make some people change from VG to DFA?

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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby Elbowman » Thu Feb 14, 2013 8:32 pm

So I'm trying to apply this information to the actual value of Vanguard Small Cap Value. My logic could be wrong in a number of places, so please tell me if I'm making a mistake.

First, in All About Asset Allocation, Rick gives a conservative estimate of 3% for the SCV premium going forward. However, I've seen people here do regression tests showing that VBR's small and value "coefficients" ( I think that is the wrong terminology) are only about 0.4, so it should only capture about 1/2 the SCV premium, or about 1.5% using Rick's estimate, correct? If a 30% small cap turnover produces a 0.9% cost, plus about 0.14% ER above TSM, are we left with only 0.5% return for 1.5% returns worth of risk?
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Tracking error of Vanguad index funds

Postby grabiner » Thu Feb 14, 2013 10:30 pm

Rodc wrote:For an index fund it would seem very easy to compute/estimate trading costs: Index return - fund return.

I wonder if it would have the same cost per 100% as shown here for some of the common index fund.


These costs, offset by revenue from securities lending, are often negative, and even when they are positive, they can be negative after expenses. All the Vanguard stock index funds I checked beat the index before expenses.

From Vanguard, 10-year benchmark return minus 10-year fund return, through 1/31/13:
Total Stock Market Index Admiral: 0.02%
500 Index Admiral: 0.01%
Value Index Admiral: 0.03%
Mid-Cap Index Admiral: -0.02% (fund beat index)
Extended Market Index Admiral: -0.11%
Small-Cap Index Admiral: 0.05%
Small-Cap Value Index Admiral: -0.16% (based on -0.02% for Investor shares and 0.14% expense difference)
REIT Index: -0.06%

International fund returns can be affected by fair-value pricing, so the numbers aren't as reliable; if Vanguard made a +2% fair-value adjustment on 1/31/2003, that would reduce the ten-year returns by 0.2% compared to the benchmark.
European Index Admiral: -0.21%
Pacific Index Admiral: -0.06%
Emerging Markets Index Admiral: 0.31% (based on 0.44% for Investor shares; this fund did not quite cover its expenses)
FTSE All-World Ex-US Admiral: 0.37% (since inception, based on 0.54% for Investor shares; this fund did not cover its expenses)
FTSE All-World Ex-US Small-Cap: 1.46% (since inception; this fund was nowhere near covering its expenses)
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Re: Tracking error of Vanguad index funds

Postby Rodc » Thu Feb 14, 2013 10:43 pm

grabiner wrote:
Rodc wrote:For an index fund it would seem very easy to compute/estimate trading costs: Index return - fund return.

I wonder if it would have the same cost per 100% as shown here for some of the common index fund.


These costs, offset by revenue from securities lending, are often negative, and even when they are positive, they can be negative after expenses. All the Vanguard stock index funds I checked beat the index before expenses.

From Vanguard, 10-year benchmark return minus 10-year fund return, through 1/31/13:
Total Stock Market Index Admiral: 0.02%
500 Index Admiral: 0.01%
Value Index Admiral: 0.03%
Mid-Cap Index Admiral: -0.02% (fund beat index)
Extended Market Index Admiral: -0.11%
Small-Cap Index Admiral: 0.05%
Small-Cap Value Index Admiral: -0.16% (based on -0.02% for Investor shares and 0.14% expense difference)
REIT Index: -0.06%

International fund returns can be affected by fair-value pricing, so the numbers aren't as reliable; if Vanguard made a +2% fair-value adjustment on 1/31/2003, that would reduce the ten-year returns by 0.2% compared to the benchmark.
European Index Admiral: -0.21%
Pacific Index Admiral: -0.06%
Emerging Markets Index Admiral: 0.31% (based on 0.44% for Investor shares; this fund did not quite cover its expenses)
FTSE All-World Ex-US Admiral: 0.37% (since inception, based on 0.54% for Investor shares; this fund did not cover its expenses)
FTSE All-World Ex-US Small-Cap: 1.46% (since inception; this fund was nowhere near covering its expenses)


Great. Thank you very much.

For Vanguard at last the trading costs seem very small (they have both plus and minus costs as you point out).

As far as I recall the Vanguard fund indexes are constructed so front running is not really an issue, though may be an issue for funds based on other indexes.
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby peppers » Thu Feb 14, 2013 10:59 pm

In my 401k:


.......................ER...............Turnover

Large Cap Blend .17 ..............7.6%

Mid-Small Blend .18 ..............7.9%

Not great but not terrible.
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby stlutz » Fri Feb 15, 2013 2:11 am

In the DFA versus VG debate, we usually cite the ER difference between the funds and the AUM fees of the advisor. I'm guessing that since DFA doesn't have to mirror an external index and engages in patient trading that this difference narrows the overall expense difference between VG and DFA. Is the difference enough to make some people change from VG to DFA?


Only if one presumes that VG engages in "impatient trading." :)

When VG's smallcap index funded was pegged to the R2000, they routinely beat the index because they front-runned the front runners.
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby Rodc » Fri Feb 15, 2013 9:08 am

stlutz wrote:
In the DFA versus VG debate, we usually cite the ER difference between the funds and the AUM fees of the advisor. I'm guessing that since DFA doesn't have to mirror an external index and engages in patient trading that this difference narrows the overall expense difference between VG and DFA. Is the difference enough to make some people change from VG to DFA?


Only if one presumes that VG engages in "impatient trading." :)

When VG's smallcap index funded was pegged to the R2000, they routinely beat the index because they front-runned the front runners.


That is a very interesting point.

From Grabinger's post, this is a non-issue in the DFA vs Vanguard debate.

Seems to be a problem with looking at industry averages, dominated by active funds and trying to apply lessons learned to well run low cost index funds.
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby docneil88 » Fri Feb 15, 2013 8:33 pm

Hi grok87, Thanks for the interesting info. There are so many potential pitfalls to active management vs. index funds: higher management fees, cost of your own time, greater market impact costs, style drift, greater capital gains tax cost, less diversification, greater total cost from the spread between bid and ask prices, greater total commissions, possible major underperformance of one's index benchmark, etc. On the other hand, an active manager has five major ways that could help overcome those pitfalls and generate outperformance relative to her benchmark index:

(1) Lower the impact of nearly all the above pitfalls by reducing her turnover (this can help a lot, but is not sufficient on its own to generate outperformance);
(2) Lower her market impact costs by keeping portfolio size small to medium sized; this also decreases the tendency to move toward closet indexing as size gets larger (keeping a portfolio a manageable size can help a lot, but is not sufficient on its own to generate outperformance);
(3) Select a portfolio with higher volatility or higher Beta than her benchmark index (this is a double edged sword; it can help in an up market, and hurt in a down market, but luckily markets tend to go up more often than down in the long term);
(4) Skillfully select securities that have higher risk-adjusted performance going forward than her benchmark index (if skill is great enough, it can generate outperformance even without the above factors); or
(5) Get lucky (i.e. be the recipient of advantageous randomness; if it's great enough, it can generate outperformance even without the above factors).

In my opinion, outside of the Bogleheads, too much attention is given to the chance of outperformance, and it's generally assumed that if outperformance goes on for a fairly long time, it's due to the skill of the person(s) doing the active management. I think outperformance is more often due to one or more of the following: reducing turnover, keeping portfolio size small to medium sized, increasing risk, or luck. The most reliable of these at increasing returns is reducing turnover. It generally reduces time spent in managing the assets; it decreases total trading costs of the portfolio (including market impact costs, commissions, total tax costs from capital gains, and total costs from the impact of spreads); it reduces style drift; it decreases the chance of vastly underperforming one's benchmark index; and it decreases the risk of buying high and selling low.

Though a non-professional individual stock picker usually pays higher average commissions per share, and doesn't have as much information at their disposal compared to a professional active manager, they do have a several major advantages: low or zero market impact costs, no management fees, no shareholders to answer to, and fewer administrative hassles to deal with. With a diverse portfolio, average volatility, at least 20-30 securities, turnover almost as low as an index, and average stock picking skill, I believe a non-professional individual stock picker can expect returns about the same as an index over the long term. Add above-average stock picking skill to that mix and they can expect some outperformance, and perhaps a large outperformance if they run a concentrated portfolio or play in the sandbox of more volatile, less efficient markets such as small stocks or emerging markets. Problem is, individual stockpickers' turnover is usually far too high: this causes many problems. I dare say, turnover is the bane of active management. Luckily, when Vanguard does employ active managers, they seem to choose ones that realize this and keep turnover low. Best, Neil
Last edited by docneil88 on Sat Feb 16, 2013 1:34 am, edited 1 time in total.
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby magician » Fri Feb 15, 2013 10:20 pm

Sounds as though someone's been reviewing implementation shortfall in the Level III CFA curriculum.

;)
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby dumbmoney » Sat Feb 16, 2013 1:49 am

There's a fundamental tradeoff between tracking error and return. An index fund with high tracking error due to slow trading (e.g. using natural fund flows to conform to the index rather than massive one shot trades) should be able to outperform in the proverbial long run. But then you have to trust the fund manager a little. Negative tracking error could be due to incompetence. With a low tracking error fund, you don't have to trust the fund manager as much (you have a perfect benchmark), but you give up some return.
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby docneil88 » Mon Feb 18, 2013 5:14 pm

magician wrote:Sounds as though someone's been reviewing implementation shortfall in the Level III CFA curriculum.

;)

:) I wish. Wow. Hang out on this board long enough, and you too can be mistaken for a Level III CFA candidate. (Magician, on the other hand, has, I think, already passed his Level III's.)
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Re: Shedding Light on Invisible Costs:Trading Costs& Perform

Postby grok87 » Mon Feb 18, 2013 8:24 pm

docneil88 wrote:
magician wrote:Sounds as though someone's been reviewing implementation shortfall in the Level III CFA curriculum.

;)

:) I wish. Wow. Hang out on this board long enough, and you too can be mistaken for a Level III CFA candidate. (Magician, on the other hand, has, I think, already passed his Level III's.)

I think he teaches the course!
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