There is an ever-growing demand from investors and regulators in the investment industry to have full transparency and understanding of how costs affect active management results and how they can effectively be managed.
While investors, practitioners and academics can identify cost factors that give rise to changes in investment performance relatively easily, there is a shortage of empirical evidence that quantifies the magnitude of such costs or the implications arising for investors engaging active managers in South Africa.
Traditionally, transaction cost research entailed performance studies that measured the extent to which portfolio returns are reduced from the execution strategies adopted by fund managers.
These costs can be broken down into two trading cost components: explicit costs, such as brokerage and taxes; and implicit costs (market impact and opportunity costs).
Although implicit costs are inherently more difficult to quantify, they do have a definite effect on an investor's performance over time.
International research suggests that market impact costs are substantial for active equity managers, and there is a high degree of variation in market impact costs that can be explained by trade size, trade direction (buys or sells), stock size, investment style, and the type of institution executing the trading package.
Market impact cost quantifies the expenses incurred by fund managers given movements in equity or bond prices, and this is directly related to the size of the trade executed by an institution.
Therefore, bigger trades will account for a higher proportion of trading volume, and subsequently the size can cause an adverse shock in the equity price.
From this logic, it is expected that larger managers typically incur higher market impact costs.
This has given rise to a demand for effective transition management in the investment industry.
Since fund manager skill in controlling impact costs varies, it makes sense that value can be added in the fund manager selection process by not only identifying managers with superior stock-picking skills, but also in hiring managers with an ability to minimise their market impact costs.
Additional implicit costs in trading are opportunity costs, which are costs incurred by patient traders seeking to avoid market impact costs, in other words, the value lost because of information decay.
Hence, there exists a trade-off between market impact and opportunity costs.
In an investment environment where the delivery of alpha becomes more and more difficult with markets becoming more efficient, fund managers' ability to recognise, quantify and manage other sources influencing investment performance (such as impact costs) is becoming increasingly important.
Investors also need to be more educated about how to assess and interpret performance results they are getting from managers.
Investors can indirectly measure the performance impact of explicit trading costs and tax by subtracting the difference between gross and net returns, after accounting for brokerage costs and other management expenses.
However, they cannot accurately quantify the extent to which market impact costs erode potential returns achievable in the market.
Investors need to stay abreast of research and developments in transaction cost analysis and assess the effectiveness of their fund managers in managing these effectively.
- Sonja Saunderson is the head of research at m Cubed Asset Management