Hidden costs of trading revealed
Most trustees have no problem in seeing why investment performance must be monitored. The success or failure of the entire fund is at stake. But when it comes to putting transaction costs under the microscope, the exercise can sometimes seem too arcane to bother with.
Still, many pension funds are commissioning transaction costs analysis reports, and given the focus on cutting costs at all levels, this number could rise.
Carla Boogers, spokeswoman for KAS Bank, says TCA information can be used to evaluate a fund manager, however it will be one of the minor items. “For example, evaluating a fund manager the performance result and the risk involved is more important,” she says.
“Not all pension funds monitor costs” says Rick di Mascio, CEO of specialist firm Inalytics, ‘But we have a good roster of pension fund clients who want to know how well their managers are dealing and what impact these costs are having on performance”
Although interest in TCA was initially kicked off by the Myners Report, pension funds saw pretty quickly, says di Mascio, that the real issue was not compliance but that these costs hit performance and they wanted to know by how much and what was being done about it.
TCA is increasingly important for pension funds, says Belinda Keheyan, spokeswoman for Investment Technology Group, a provider of technology-based equity trading services and transaction research.
“This is part of the rationale behind ITG’s planned acquisition of Plexus which historically has been stronger than ITG in servicing the plan sponsors themselves,” she says. The TCA practiced by Plexus - a Los Angeles-based subsidiary of JPMorgan Chase Bank - is more consultative in approach, says Keheyan. She claims that this, coupled with ITG’s superior technology makes the combined offer the best on the market.
Pension clients are becoming increasingly better informed about costs and realise that transaction costs can make the difference between top and bottom quartile performance, she says.
Chris Angell, principal at Mercer Investment Consulting, says transaction cost analysis can unearth areas where costs can be cut. “There are a lot of hidden costs in execution,” he says. “If one can devote time and energy to those costs, then one can reduce costs quite considerably. What gets measured gets managed.”
Providers of transaction cost analysis still face the task of making pension funds aware of what the service can do for them. “We still have to get them to understand the benefits it can provide from a management standpoint,” says John Barlow, director, product management at Northern Trust Global Investments.
Performance measurement is seen as key for pension funds, but increasingly, there is an awareness of the transaction cost measurement. Barlow says he believes there are a lot more benefits to transaction cost analysis than people realise.
“Initially some of the reporting that is out there has tended to be quite complex and involving quite a lot of data. It has been difficult to analyse because you need to have the tools to manipulate that data,” he says.
Also, the data used in transaction cost analysis are now more up-to-date. Before, the information analysed was often three or six months old. “People were having a problem seeing the relevance of that.”
NTGI has simplified the product, so that what the end user sees is a straightforward summary of data, says Barlow. It is very accessible and available on NTGI’s online client reporting system, known as Passport. In addition to the explicit costs of commission, local taxes, and so on, it has focused on , the VWAP (Volume-Weighted Average Price) benchmark for measuring the implicit costs associated with the trade.
“We take that price and compare it to the daily VWAP and let the user see how much that varies against the VWAP,” he says. “It is not intended to be a panacea, but a tool to let the user see whether there are trends. If any trend starts to reveal itself, it gives them some good ammunition when they have their review with managers to sit down and ask why that has happened.”
With education and the focus on transaction costs, Barlow predicts there will be more pension funds using the tool in future.
When a pension fund decides to undertake transaction cost analysis, it has to decide what depth of data it wants. How much detail a pension fund needs really depends on the fund, says Angell. There are some funds where it would not be worth going into great detail, because the costs of analysis are significant.
“It’s a danger that if the trustees haven’t got the time to make use of the information, then it’s bewildering,” he says. If funds take the service through a consultancy, then the consultants can interpret it and highlight the significant points. For example, Mercer’s Sentinel service provides funds with the analysis and the interpretation, he says.
Most pension funds would be well advised to look for an independent analyst. “It’s important one has an independent review,” says Angell. Specialist providers include Plexus, Elkins/McSherry and GSCS.
Robert Kay, managing director of specialist firm GSCS Information Services, says the large funds in Europe are very conscious of the effect costs can have on their long-term performance. “But transaction costs are somewhat esoteric… They don’t tend to dominate trustees’ thoughts,” he says.
Still, transaction costs are significant, he says, and are the second largest cost after asset management fees, when one takes into account market impact and opportunity cost -- the cost of delays, where large trades are executed but which cannot be completed within one day, usually because of liquidity.
Di Mascio says the trouble with measuring costs against VWAP is that this only captures the cost of trading on a particular day. “It doesn’t capture the real cost that is built up when dealing over a number of days… that’s where you get the real price slippage,” he says. This is opportunity cost, and it should be measured, he says.
How opportunity cost is managed differentiates the good desks from the bad as it depends on how well they read the market, tap various sources of liquidity and manage the relationships with brokers, he says. “There’s an assumption that there’s randomness to price moves from one day to the next, but a good dealer can read the market and benefit from volatility,” he says.
How much detail is given in transaction cost analysis? “In most cases, it gets as detailed as the pension fund wishes it to get,” says Kay. The analysis can include components of trades, for example, market impact and opportunity cost, he says.
“We would look at the costs incurred by country, by broker,” he says. “We particularly look at manager-broker pairs; we look at those larger relationships and perform a health check to see if those relationships are working in the way the pension fund would expect them to.”
A thorough analysis of transaction costs can identify anomalies, he says. For instance, a manager may have a close relationship with a broker that may not work for the particular type of assets that are being looked at, he says.
What do funds do with the information? A lot of funds do not do anything with it, he says. “But that is in the process of changing. As people become more confident… they are increasingly willing to raise with the manager the trades they are doing with particular brokers.”
There are also side benefits of having transaction cost analysis carried out. It can bring certain details to the attention of trustees, such as why results in a particular investment area are disappointing, or why a particular stock is being held that performs poorly.
ABN AMRO Mellon outsources transaction cost analysis on behalf of pensions clients. Nigel Taylorson, client relationship manager UK and Ireland at ABN AMRO Mellon, says that take up of the service is variable.
“Some clients say we just want the manager to do well, and if he does, then we don’t care about the costs,” he says. But like others, Taylorson points to the hidden costs within trading expenses. Including delay and impact, transactions can cost around 87 basis points, with only 15 basis points of that in commission.
But once a pension fund has the information on exactly how much transactions are costing it, can it really use the data effectively and reduce expenses?
“Some definitely use it,” says Taylorson. “What happens is that it certainly puts managers and brokers on their guard when they know they are being watched.” There seems to be evidence that in these cases the delay and impact cost is reduced over time. “It tightens up just by virtue of the fact they know it is being watched,” he says.
Frits Bosch, director of Netherlands consultancy Bureau Bosch, says scrutinising the cost of transactions is still a point which is slightly neglected. “It gives pension funds insight into what is really going on on that side,” he says. “There could be a lot to gain.”
He says that investment costs are not generally as expensive for pension funds in the Netherlands as they are for counterparts in the UK. This is partly to do with history. “We started with Robeco as a co-operative asset manager,” although it now operates in line with other asset managers. But whether fees are lower or higher in the Netherlands, they are not very transparent, says Bosch.