October 27, 2015
Combating Hidden Trading Costs: Here Be Dragons
In days of yore, navigational maps were often illustrated with dragons and sea monsters, indicating that danger was afoot on the high seas. The imagery may have been mythical, but the risks were real enough, especially for travelers who failed to equip themselves for the journey. To this day, risk and reward remain tightly connected for those venturing into our global markets. In seeking market returns, we must equip ourselves with reason and evidence, separating fact from fiction to tackle the real dangers that lie in wait. Hidden trading cost is one such elusive but formidable foe.
Trading Costs: Now You See Them, But Sometimes You Don’t
Some investment expenses are easier to spot than others. For example, a fund’s expense ratio must be disclosed in its prospectus, and when you buy or sell shares of a security you should see a brokerage fee appear in your trade confirmation statement. You may or may not take the time to scrutinize these costs, but at least they are in plain sight. (In fact, if these sorts of costs are not readily disclosed, that is a red flag in and of itself.)
Then there’s the assortment of trading costs that are not as apparent as directly reported expenses. Among the financial professional and academic community, these are sometimes referred to as “friction costs” – invisible forces that drag unseen against your end returns.
The Hidden Damage Done
If we can’t directly see hidden costs, how do we know they’re there? Similar to the way physicists study gravity, capital market researchers seek to measure hidden costs by observing the effect they have on what can be more readily seen: the end returns you receive from your investment, compared to other, similar kinds of investments.
For example, imagine you are comparing paints for your home renovation project. Brand A and Brand B both cost $25/gallon. At first, it may seem there’s no difference in price. But what if you learned that you’d need two coats of Brand A to achieve the same coverage that Brand B provides in one coat? By observing the end results of this hidden cost, it’s easy to see it showing up as real dollars spent from your wallet.
Studies have indicated that hidden costs can add up in significant ways as well. “Shedding Light on ‘Invisible’ Costs” is one such piece, published in the January/February 2013 Financial Analysts Journal. According to the paper’s abstract (emphasis is our own), “The authors found that funds’ annual trading costs are, on average, higher than their expense ratio and negatively affect performance.” A report on the same study posted by the UC-Davis Graduate School of Management noted, “Funds’ average annual expenditures on trading costs (i.e., aggregate trading cost) were 1.44% compared to their expense ratio of 1.19%. And there was considerably more variation in fund trading costs than in expense ratios.”
How To Slay a Dragon: Step One, Spot the Dragon
Hidden trading costs can be difficult to combat; they are by definition elusively observed and slippery to measure. Most investors are unaware they even exist. So the first step in minimizing them is to familiarize yourself with them. Some of the more notorious friction costs include bid-ask spreads, market-moving costs and opportunity costs.
Bid-ask spreads are the difference between the highest price a buyer wants to pay for a security (the bid) and the lowest price a seller wants to accept (the ask). For example, if a buyer hopes to purchase a security for $10/share but the seller hopes to receive $11/share, the bid-ask spread is $1. Whoever “loses” in the transaction by selling for less or paying more than desired incurs a hidden cost; they are essentially starting out $1 behind on the end return they were seeking to receive.
If you, as an individual investor, decide to sell or buy 50 shares of Whizco stock today, the current price will be the price at which you trade all 50 shares. The rules change when a major market player such as an institution or mutual fund seeks to rapidly trade enormous blocks. In a classic case of supply and demand, when the market notices a trader who is anxious to buy or sell large lots, it reacts by temporarily moving the supply price up or down and widening the bid-ask spread against the demanding trader. This generates market-moving costs before the trading is completed. For example, index funds face market-moving costs when they must rapidly buy or sell positions after their underlying indices reconstitute. They end up paying more for their buys and receiving less for their sells than would otherwise be expected.
Market Opportunity Costs (Moving to Cash)
In the broadest sense, opportunity costs are incurred when you commit to one opportunity that is less desirable than another. In investing, it means committing your assets to one strategy when another would have offered better results, given your particular goals. The cost is the difference between the value of the position you took versus the one you could have had instead.
The academic evidence on the factors that drive long-term market returns informs us that a highly efficient way to participate in the market is to simply be there: patiently, globally diversified, cost-effectively, capturing expected returns when and where available, according to individual risk tolerances. In the absence of this sort of disciplined strategy, it’s easy to forever torment yourself by considering every “opportunity” the markets make available. Fund managers aren’t immune to this same angst, which is why significant market opportunity costs can occur when they disregard this body of evidence and instead seek to second-guess the market, moving to cash when markets turn volatile and trying to predict when it’s time to move back in.
In his classic, “Common Sense on Mutual Funds,” Vanguard Group founder John Bogle explains: “The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”
Combating Hidden Costs: Our Role as Your Advisor
Now that you have familiarized yourself with these hidden costs, how should you proceed? As an investor, your goal is to seek fund managers who are best positioned to:
- Reject unfavorable bid-ask spreads when they’re trading
- Avoid having to place large, hurried trades that incur market-moving costs
- Avoid market timing and its related opportunity costs, and instead focus on market factors that are more readily under our control.
Traits to seek that enable this level of managed trading include:
- A scientific approach, based on the academic evidence on how our markets have delivered long-term wealth. This helps minimize unnecessary and ill-timed trades and associated costs.
- Patience to be on the “cool” rather than the “hot” side of the trades. It’s only logical that those who are anxious to secure or unload a position won’t receive the best deals.
- A demonstrated commitment to client care by aggressively minimizing hidden trading costs and demonstrably passes those cost savings on to you and other fund shareholders in the form of minimized expense ratios and higher long-term performance compared to appropriate benchmarks.
Identifying fund managers who meet these qualifications and ensuring that they remain true to their policies and procedures is a role we take very seriously at [Your Firm Name]. Combating hidden costs is part of our fiduciary obligation to serve your highest financial interests, and one of many ways we feel we handily offset our own, fully transparent advisory fees. Contact us today to learn more.
We would love to invite you to learn more about Hiley Hunt Wealth Management and who we serve in Omaha, NE –Financial Planning and Investment Management.