Paul Richards: A deep dive into transaction costs
By Paul Richards
What do the Mifid II cost disclosure requirements mean for advisers?
Since fund groups have had to start disclosing portfolio transaction costs as part of the Mifid II requirements, there has been considerable attention on how PTCs impact the total cost of ownership.
However, what has been somewhat overlooked is the fact that these costs are not new and nor do they mean that clients are incurring higher costs than before. All that has really changed is that they now have to be to be clearly disclosed to investors ahead of investment.
Previously the cost of buying and selling securities was typically shown within a fund’s report and accounts.
That figure only included explicit costs incurred over the year, such as broker commissions and levies such as stamp duty. Bid-offer spreads – the difference between the buying and selling prices of securities – were reported separately.
The new disclosure rules mean both explicit and implicit costs, such as bid-offer spreads, must now be included within the reported figure.
What has caused a stir among commentators is ‘slippage’, and how it, too, is regarded as an implicit cost.
What is slippage?
Slippage is the impact of any change in the price of a security between placing and executing a trade. It arises from market movement during any delay in transacting and can be positive or negative.
Negative slippage: A manager decides to sell a stock at 11am when the mid-market price is 95p (this is known as the arrival price). The transaction is executed at 12.30pm, by which time the bid price has risen to 99p. The slippage cost on the sale is therefore -4p (a negative cost under Mifid II rules.)
Positive slippage: Conversely, at the same time, another manager wants to buy the same stock at 95p. However, by the time the order is executed at 12.30pm, the offer price has risen to 101p. The slippage cost on the purchase is therefore +6p.
To complicate matters there are a number of factors that have an impact on ‘slippage’, including the effect of large inflows and outflows moving prices. So, you could easily argue that it’s not a cost at all – it just reflects whether the market moved in a favourable way or not.
Another reason why slippage is particularly problematic is because Mifid II rules state that PTC calculations should be based on up to three years’ historic data. However, many managers have not recorded arrival prices over the past three years, as up until Mifid II they had no need to, and so cannot accurately calculate the true slippage cost.
As a result, some managers have to instead rely on a number of pricing points to estimate slippage, such as the opening price on the day of the trade or the closing price on the preceding day.
Why do transaction costs vary so much?
You may have noticed that the reported transaction costs can vary widely, with some figures around +2 per cent and others below zero.
While slippage can account for many anomalies, such as negative, zero and very high figures, the lack of consistency when calculating figures also plays a huge part in the reporting of PTCs.
Much of this inconsistency is because there is no standard method of calculating PTCs. It can also be difficult to quantify implicit costs and the regulations allow a number of calculation options.
What’s also surprising is that fund groups are not required to disclose which calculation method they use. The Investment Association has therefore raised concerns about how PTCs are calculated and has called on regulators to conduct a review.
Should transaction costs be used to compare funds?
There can be no denying that costs will always be an important consideration when selecting funds for your clients. In particular, ongoing charges figures allow you to make direct cost comparisons between similar funds.
While PTCs are a charge that has not previously been explicitly disclosed, using these to make like-for-like comparisons between funds is more for the reasons highlighted above.
Of course, charges are just one measure of value for money when investing in a fund. In my opinion, the best like-for-like comparison between funds remains net performance – the return after both the ongoing charges figures (OCFs) and PTCs have been taken into account. It’s also important to remember that net performance will not change as a result of the new disclosure rules, as these have always been reflected in the figures.
Paul Richards is head of sales at FundsNetwork