27 Mar The trouble with transaction costs (plus the top 20 funds of 2017)
The introduction of transaction cost disclosure was intended to provide greater transparency. However, with an utter disregard for common sense that characterised MiFID2’s generally inglorious introduction, the regulators provided fund managers with two diametrically opposed calculation methodologies. As a result, fund managers, ACDs, data providers and platforms have between them contributed to organisational chaos.
Advisers have noticed that some platforms’ numbers quoted online did not tally with data providers’. Or they found that other platforms’ online numbers didn’t tie up with subsequent illustrations. And some platforms (Transact for example) refused to use negative numbers because they would be counter-intuitive and likely therefore to be counter-productive.
While negative transaction fees have attracted a significant amount of attention, we should probably be more shocked at the idea of zero transaction fees than negative ones. Every fund has trading activity through tax, liquidity and stock-broker commissions. However, some boutique managers are not sure their ACDs have calculated the numbers correctly, since they know they can’t be zero.
The table below shows the top 20 funds by net sales in 2017 as reported by platforms to Fundscape. We have included OCFs, transaction costs and three-year returns and alpha. None of the funds have negative transaction costs, but a handful have zero transaction fees.
Some industry commentators have been drawing attention to high transaction costs, but without providing relevant context. Transaction charges are not hidden charges with which to fleece investors nor are they a reason to point fingers at fund managers. High transaction costs do not equal bad funds; a cheaply priced index tracker, for example, is likely to have a higher proportion of transaction costs than an active fund, as evidenced by the Vanguard LifeStrategy fund in the table above. Equally, there are two funds in the table with particularly high transaction costs — one is a strong performer with three-year alpha and the other is not. Which fund would you recommend to your client? It is wrong to look at transaction costs in isolation.
What went wrong?
Much of the confusion stems from two conflicting instructions given to ACDs and compliance teams concerning the calculation of implicit costs, rather than the obvious explicit costs like SDRT, stockbroker commissions and the spread on the security. MiFID2 regulations specify that firms must only consider costs ‘which are not caused by the occurrence of underlying market risk’.
Market movements between the initiation of a transaction and its completion (known as ‘slippage’) should therefore NOT be included in transaction costs. After commissions and taxes are considered, an estimated spread is calculated to account for implied costs. Using proxy market spreads for each asset class which have been recommended by regulatory bodies, the calculation of implicit costs is straightforward – the security’s spread multiplied by portfolio weight, and then by turnover rate.
Unfortunately, Priip Kiid transaction cost methodology explicitly requires the inclusion of market movements. The European Securities and Markets Authority (ESMA) suggested firms use the Priips Regulatory Technical Standards calculation methodology to ensure that both explicit and implicit transaction costs are captured, using all trades over the previous three years, for the purposes of both MiFID2 and Priips obligations.
Regulators, ACDs and platforms were ill-prepared and have let advisers and investors down badly. It’s time they got their act together. The FCA has been working on a uniform fee template, but it will take a while for the industry to agree a standard method of disclosure.
Photo by marc liu on Unsplash