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The Transaction Costs Manual What Is Behind Transaction Cost Figures and How to Use Them October 2020 Contents

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The Transaction Costs Manual What Is Behind Transaction Cost Figures and How to Use Them October 2020 Contents For professional investors and advisers only In Focus The transaction costs manual What is behind transaction cost figures and how to use them October 2020 Contents Introduction 3 Part 1 What are transaction costs and how do they relate to best execution? 4 Explicit transaction costs 4 Implicit transaction costs 5 Where does “best execution” fit in? 7 The key takeaways 8 Part 2 How to measure transaction costs 9 The estimation conundrum 9 What does the regulation say? 10 The additional complication: fund pricing and the “offset” 13 The key takeaways 14 Part 3 The relationship between transaction costs and returns 15 Pricing 15 Timing 15 More trading means… 15 Different transaction costs, different returns 16 The key takeaways 17 Part 4 The mystical transaction cost figures and how (not) to use them 18 Different funds, different transaction costs 18 How not to use transaction cost figures 20 How to use transaction cost figures 21 The key takeaways 21 Conclusion 23 2 The transaction costs manual What is behind transaction cost figures and how to use them In this paper we (attempt to) tackle the complicated issue of transaction costs. We outline what one needs to know about reported transaction costs and explain how to avoid common pitfalls when using them. Author To cut what is a very long story short: – transaction costs are a necessary part of investing; – estimating them is complex; – no two trades are the same so transaction cost figures should not be compared in isolation; – and, finally, higher transaction costs do not mean a more expensive fund or lower returns. At the end of the day, all transaction costs, measurable or not, are Anastasia Petraki embedded in the returns investors get. Head of Policy Research Introduction Although, to the wider world, January 2018 did not signify The first part of the manual starts with what transaction costs anything extraordinary, it did mark a new era for costs and are, explains why some are intangible and discusses how they charges transparency in the investment fund market. The relate to another technical term: “best execution”. two pieces of European regulation that came into force at the time – the Markets in Financial Instruments Directive II (MiFID The second part covers the critical question of how one can II) and the Packaged Retail and Insurance-based Investment measure transaction costs and outlines the challenges with Products (PRIIPs) – have been a game changer in the way the estimating the overall cost of trading. cost of investing in a fund is communicated to investors. For the first time, people were able to see not only the ongoing cost The third part explores how transaction costs are connected to associated with being invested in a fund but also how much the returns and why their relationship is not linear. transactions carried out by portfolio managers were costing The fourth and final part of this manual brings everything them in total. In parallel, new rules came into force in the UK together to answer the most important question: how to use requiring the reporting of transaction costs for workplace and not use reported transaction cost figures. defined contribution (DC) pensions. Where relevant in this four-part manual, there is empirical There is a certain mystique about transaction costs. Some analysis which is based on MiFID II transaction cost figures. of it has to do with long-standing suspicions that they are The PRIIPs disclosure regime remains so fraught with issues hidden. Some of it is because a part of transaction costs is so – which, almost three years since its introduction, remain intangible that it borders on theoretical. At the time when the unresolved – that it is not covered here. As an indication of new disclosures came into play, many attempted to explain how complicated this is, suffice it to say that cost disclosure in what the numbers meant and how they should be interpreted. PRIIPs is not consistent with that in MiFID II, so that investors But the transaction cost mystique is persistent. Despite see different numbers for what should be the answer to the everyone’s best efforts, almost three years into MiFID II, we same question: how much did I pay? The debate around this observe three common pitfalls among users of the disclosed is currently ongoing. Despite this, how transaction costs are transaction cost figures: estimated and presented to investors does not alter what these – Comparing the transaction cost figures of different figures mean and how they can be used. funds in isolation, that is, without accounting for any If there is one thing people should take away from other fund characteristic, market conditions or investors this manual, it is that this is a complicated matter, but buying into or selling out of a fund. understanding it is necessary in order to use transaction – Considering that higher transaction costs mean a more cost figures in a meaningful way. It is not meaningful to expensive fund. look at them out of context or to compare transaction cost – Expecting that lowering transaction costs will result in figures in isolation, as no two trades are the same. And, higher returns. even if there is no one reliably exact way to estimate total transaction costs, these costs are fully reflected in the The purpose of this ”manual” is to explain exactly why all returns that investors receive. three assumptions are wrong. To do this, we need to go back to basics, to cover the technical aspects behind transaction costs and explain the many intricacies around how they are connected to fund types and returns. We do this in four parts. 3 0 2 4 6 8 1 1 B By region Source: VirtuFinancial. Informationasof2019. Source: markets different forlistedequitiesacross 1:Commissionas%ofvaluetraded Figure costs and how do they relate to to relate they do how and costs Part 1: What are transaction considered ‘excessive’. considered were investinginafund,unlessthey that peopleseebefore documents,thatis,documents notdisclosedinpre-sale were infundaccounting.They and henceneedtobereported somethingthatthefundpays are asthey annual longreports disclosedinfunds’ IIworld,thesecostswere In thepre-MiFID such typesofpayments: are two assets.There from the fund’s anoutflow reflect directly occurand when they obvious This meansthatthesecostsare tocarryoutatransaction. partiesinorder is paidtoknown toa costsrefer Explicit transaction Explicit transaction costs inthestrictestsense. termed a“cost” the actualnumbermeanssomethingthatcannotbeexactly toestimate,and tounderstand,harder harder are because they timetalkingaboutthelatter bothbutwespendmore cover We ofbuyingandselling(“ duringtheprocess the market (“ an actualpaymenttosomeonecompletethetransaction Somereflect reasons. costsarisefordifferent Transaction cost.creates investment return onecan that is,buyand/orsellsecurities.Thisishow transactions, yourself investororafundmanager–hastomake aninvestment–beitado-it- Anyone whowantstomake best execution? 0 2 p explicit 4 s ( % United States v a l ”) and some reflect the theoretical valuethatislostto thetheoretical ”) andsomereflect u e Japan t r a d e Europe ex UK d ) but transacting isnotfrictionlessand buttransacting United Kingdom commission andtax Canada Asia Pacific ex Japan very specificsum Emerging Asia Emerging Europe . Emerging Markets that get an implicit Latin America Middle East and Africa ”). 0 2 4 6 8 1 1 1 1 B By regionansie no stamp duty when selling shares ofUKcompanies no stampdutywhensellingshares is there notnecessarilysymmetrical.Forexample, are Such taxes ofaUKcompany. of0.5%whenonebuysshares Reserve Tax isaStampDuty there Forexample, ataxontransacting. literally ortaxauthorityanditisThis isthepaymenttolocalrevenue Tax and faster. efficiently happensmuchmore matching buyandsellorders systems,where usingelectronic itcostslesstotrade Moreover, securitiesofsmallercompanies. andwhentrading markets capital speaking, commissionishigherinlessdeveloped so,broadly volatilemarkets inlessliquidandmore to trade itcostsmore 1).Generally, (Figure the amountthatistraded and(sometimes) inwhichitistraded theregion security traded, The amountspentoncommissionwillvarydependingthe partforthem. oftheadministration care and takes transacting the intermediaryservicebetweenthosewhoare partyprovides (such asclearingandsettlement)thethird transaction componentisinvolvedinevery administration whythispaymentisneededbecauseanThe reason in aspecificvenue. which isthepriceonehastopayforbuyingorsellingasecurity fee, commission willincludeotherfeessuchasanexchange oftenthannot,the More suchasabroker. the transaction partywhoexecutes Commission isthepaymenttothird Commission 1 etc.trade), issuedandchangeshands(secondaryor onethatisalready forthefirsttime(primarytrade) isforasecuritycreated trading placein,whetherthe takes what typeofvenuethetrade 2).Thisdependsonthetypeofsecuritiestraded, (Figure are highthetaxrates applyandhow taxes when thetransaction asto differences are andthere regime country setsitsown tax.Each inasecuritythatissubjecttotransaction to trade andcannotbeavoidedifonewantsThe taxcomponentisfixed 0 2 4 6 p made from owning thatsecurity. owning made from onehas andwhichiscalculatedbasedontheprofit in theUK(includingshares) There is, however, acapitalgainstax,whichapplieswhensellinganysecurity is,however, There s ( % Asia Pacific ex Japan v a l u e Canada t r a S d m e d a Emerging Asia l ) l C a p Emerging Europe M i Emerging Markets d C a p Europe ex UK L a Japan r g e C a Latin America p Middle East and Africa 1 . 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