The Hidden Costs of Trading

The cost of trading clearly imposes a drag on the performance of portfolio managers. As we debate the extent of these costs, we need to get a measure of what the costs are, how they vary across investment strategies and how investors can minimize these costs. In the previous chapter, Robert Arnott discussed some of the difficulties associated with the measurement of trading costs, and noted the debate between those who think trading costs are too high, taking an expansive view of what comprises these costs, and those who argue that it is negligible from the perspective of the entire market.

In this chapter, we will take a middle road, where we will look at the ingredients that go into trading costs, and examine the kinds of strategies where trading costs are likely to be high and those where they will generally be low.

While we debate what constitutes trading costs and how to measure them, there is a fairly simple way in which we can estimate, at the minimum, how much trading costs affect the returns of the average portfolio manager. Active money managers trade because they believe that there is profit in trading, and the return to any active money manager has three ingredients to it:

Looking across all active money managers, the average expected return has to be equal to the return on the market index. Thus, subtracting the average return made by active money managers from the return on the index should give us a measure of the payoff to active money management:

Average Return_{Active Money Managers} — Return on Index = Return from Active Trading — Trading Costs

In chapter 8, we noted that the average active money manager has underperformed the index in the last decade by about 1%. If we take the view that active trading adds no excess return, on average, the trading costs, at the minimum, should be 1% of the portfolio on an annual basis. If we take the view that active trading does add to the returns, the trading costs will be greater than 1% of the portfolio on an annual basis.

The paper portfolio had an annual return of 26.2%, whereas the Value Line fund had a return of 16.1%. While part of the difference can be attributed to Value Line waiting until its subscribers had a chance to trade, a significant portion of the difference can be explained by the costs of trading.

Looking at the evidence, there are a couple of conclusions that we would draw. The first is that money managers either under estimate the trading costs, over estimate the returns to active trading or both. The second is that trading costs are a critical ingredient to any investment strategy, and can make the difference between a successful portfolio and an unsuccessful one.

There is a difference between that a buyer will pay and the seller will receive, at the same point in time for the same asset, in almost every traded asset market. The bid-ask spread refers to this difference. In the section that follows, we will examine why this difference exists, how large it is as a cost, the determinants of its magnitude and its effects on returns in different investment strategies.

In most markets, there is a dealer or market maker who sets the bid-ask spread, and there are three types of costs that the dealer faces that the spread is designed to cover. The first is the risk cost of holding inventory; the second is the cost of processing orders and the final cost is the cost of trading with more informed investors. The spread has to be large enough to cover these costs and yield a reasonable profit to the market maker on his or her investment in the profession.

1. The Inventory Rationale

Amihud and Mendelson present a simple model of a market maker who has to quote bid prices and ask prices, at which he is obligated to execute buy and sell orders from investors. These investors, themselves, could be trading because of information they have received (informed traders), for liquidity (liquidity traders or based upon their belief that an asset is under or over valued (value traders). In such a market, setting too high a bid price will result in an accumulation of inventory to the market maker, whereas setting too low of an ask price will result in an increase in the market maker’s short position.

Amihud and Mendelson argue that market makers operate with inventory constraints, some of which are externally imposed (by the exchanges or regulatory agencies) and some of which are internally imposed ( due to financial and risk reasons). As the market maker’s inventory position deviates from his or her optimal position, the prices will be different from the preferred prices; if the inventory is too high, the prices will be lower than the preferred prices; if the inventory is too low, the prices will be higher than the preferred prices.

Since market makers incur a processing cost with the paperwork and fees associated with orders, the bid-ask spread has to cover, at the minimum, these costs. While these costs are likely to be very small for large orders of stocks traded on the exchanges, they become larger for small orders of stocks, that might be traded only through a dealership market. Furthermore, since a large proportion of this cost is fixed, these costs as a percentage of the price will generally be higher for low-priced stocks than for high-priced stocks.

The adverse selection problem arises from the different motives investors have for trading on an asset — liquidity, information and views on valuation. Since investors do not announce their reasons for trading at the time of the trade, the market maker always runs the risk of trading against more informed investors. Since the expected profits from such trading are negative, the market maker has to charge an average spread that is large enough to compensate for such losses. This theory would suggest that spreads will increase with the proportion of informed traders in an asset market, the differential information possessed, on average, by these traders and uncertainty about future information on the asset.

The New York Stock Exchange reported that the average bid-ask spread across all NYSE stocks in 1996 was $0.23, which seems trivial especially when one considers the fact that the average price of a NYSE stock is between $ 40 and $ 50. This average, however, obscures the large differences in the cost as a percentage of the price across stocks, based upon capitalization, stock price level and trading volume. A study by Thomas Loeb in 1983, for instance, reported the spread as a percentage of the stock price for companies as a function of their marker capitalization for small orders. These results are summarized in Table 12.1.

Table 12.1: Bid Ask Spread as Function of Market Capitalization