Viewed from the angle of the major institutional investor, transaction costs around purchases and sales do not appear high in relative terms. All the same, the switch from gross to net is frequently problematic. And the problem appears to be greater in Europe than in, for example, the US. This is partly linked to the fact that in Europe brokerage and asset management is often the task of a single party. The relatively visible cost component (asset management fee) is low compared with the usual situation in the US - as much as 30 basis points or more lower. At face value that looks fine, but a snake is lurking in the grass. The big banks - still the dominant players in asset management - often carry out their own transactions.
The brokerage costs are relatively high compared with the US norm; on top of that, transparency is patchy. And, in the absence of a structured, clearly defined investment processes, the combination of asset management and brokerage within a single party spells potential for sub-optimal transactions in that stocks and bonds may be purchased for portfolio X (pension fund A) and sold from portfolio Y (pension fund B); and this can occur in such a way that the overall interest of the big bank is served more than that of the clients.
The division between asset management and brokerage that is so common in the US, certainly offers major plus points when viewed from the client's angle.
The parties most likely to encounter problems in this context are institutional investors seeking to conduct an active and disciplined investment strategy, either in-house or through an external asset manager. This is very certainly the case where the investment strategy comprises smaller, less liquid securities. If this type of strategy is practised on the basis of agency brokerage, whereby the risk of implementing the transaction lies with the investor, there is a considerable element of uncertainty as to transaction costs (including market impact costs) and hence also as to the eventual positive or negative impact of changes in the portfolio.
The degree of variability of expected transaction costs also makes it particularly difficult to slot in these costs as an integral component in the investment system. The nuisance here is that some small or micro caps may be highly tradable while these companies are in the news. But once demand declines, maybe in response to negative reporting about the stock, tradability becomes very problematic - at least under agency brokerage.
One solution is 'principal brokerage'. With this method of carrying out transactions the risk lies with the broker. In the Netherlands both our company and ABP, the world's largest pension fund, work on the basis of principal brokerage. This means that both companies can provide structured and disciplined investment strategies with a relatively high turnover. Principal brokerage reduces the market impact for the investor whereby volatility and transaction costs are significantly lower; in fact this is true to such an extent that it is quite rational to input a previously determined average transaction percentage in calculations.
This is how the method works: A buy/sell list is determined on the basis of a given, structured investment strategy. The stocks on the buy list are numbered from B1 to Bm inclusive. The funds on the sell list are numbered S1 to Sn inclusive. The broker gets key information on these stocks eg: i) volume of transactions in the given stocks; ii) percentage of the free float of the stock to be sold or bought; iii) the number of days trading in a given stock for purchase or sale; iv) whether or not the stock is listed in a major index, etc. The only information absolutely excluded is the name of the stock.
Theoretically a broker should be able to find out the name, but this is prevented by the relatively short space of time between giving the list of stocks to the brokers and their deadline for a proposal. The broker is required to make a proposal as follows: x basis points of the middle rate. After this, at a pre-arranged time, the presenting party decides that broker X may proceed with the trade, for own risk and account. After this has taken place, the broker is told the names of the stocks and can go ahead.
Judging by past experience, brokers are keen to join in the game, albeit after a hesitant start whereby a trade is eventually given to the broker with the cheapest proposal. The exception is if the particular broker has already had several trades in a row. In that case it makes sense to look for someone else - maybe the next cheapest. If this is not done, there is a possibility that the cheapest broker could deduce the portfolio and so act to stretch the bid-ask spread for smaller funds (acting together with colleagues).
This modern basket trading methodology is not designed to fool the broker, and investors should consider carefully before making the switch. It is very much a live and let-live situation. Certainly, when the method puts pressure on average transaction costs per trade, it's bad news for the broker. However, the other side of the coin is that it enables parties with structured investment processes to make more frequent changes in their portfolios. Hence, rather than reducing overall trading volume, there is an opposite effect; stable transaction costs and possible incorporation of these in investment models encourages extra business - and that is very good news for the brokers. What frequently happens, is that the party offering a trade gives the broker the buy/sell list at a set time (e.g. once a month). The broker knows that after the bid request timed at t, new requests will follow at t+1, t+2, etc. That spells very large trades and interesting opportunities to make money for relatively little effort. In the longer term the net outcome of the interplay between investor and broker is good for both parties. And, as well as being good for the price forming of these small and micro caps, the improved chances created for bigger investors to trade in smaller stocks, are also beneficial for the economies of countries where these stocks have so far not been able to count on larger institutions as investors or potential investors.
Erik L van Dijk is chief executive officer of Palladyne Asset Management in Amsterdam, an affiliate of United Asset Management in the US.