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Vol. VIII, No 2

August 2012

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Asset Owners Should Measure Turnover Rates in Conjunction with Trading Costs In order to fully understand and manage portfolio management costs, turnover rates should be evaluated based on the actual implicit1 and explicit2 costs associated with each trade. In concept, most investors are cynical of high turnover; however in certain cases, high turnover can be justified. Regardless of the overall result on portfolio turnover, these are areas of portfolio management that must be quantified in order to properly oversee money managers. According to the SEC, churning “occurs when a broker engages in excessive buying and selling of securities in a customer’s account chiefly to generate commissions that benefit the broker.” Churning, one of the most elementary forms of unethical behavior on Wall Street, is mostly associated with retail investing. Since regulatory bodies have placed a great deal of pressure on managers that utilize an internal broker/dealer this concept really does not spark as much criticism from the institutional investing community. However, there is another less malicious form of high turnover, which for simplicity purposes, I will call “high cost portfolio management strategy.” Again, I would like to point out that high cost portfolio management strategy does not automatically guarantee poor performance, however, it needs to be understood as it does create a larger hurdle for investors to overcome. One-way active US equity trading costs including brokerage commissions, fees and implementation shortfall averaged +40.27 basis points in 2Q12. Considering an 80% turnover rate, a $10 billion dollar portfolio would have incurred over $32 million dollars in trading costs. In most instances, these are the largest institutional portfolio management expenses. Interestingly enough, although trading cost is the largest and only variable expense in managing a portfolio, these costs are many times the least understood and quantified. Consultants and asset owners spend countless resources to understand and manage investment management fees. Many public pension funds post detailed quantification of these fees on their websites and spend countless hours of investment board time reviewing these fee details in order to satisfy compliance and management concerns and to avoid conflicts of interest. Investment fee transparency may certainly yield benefits, but no more or less than the management of trading costs. Additionally, reducing conflicts of interest is certainly motivation enough to quantify and fully understand your trading costs.

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Non transparent expenses such as market impact, reversion and opportunity costs. Transparent expenses such as commissions and stamp duties.

© 2012 Elkins McSherry LLC. All rights reserved. -1-

Vol. VIII, No 2

August 2012


A mega financial conglomerate, as it operates, may own interests in money management, brokerage, exchange/ venue, consulting and even pension assets. This interconnectivity of global financial markets requires greater oversight than ever in order to satisfy conflict of interest concerns. Trading is at the nucleus of these potential conflicts. As commission rates are squeezed and traditional equity volume slows, brokers are turning to venue rebates in order to make up lost revenues. Since most asset owners do not fully understand money manager and broker smart order routers, which are being utilized on their behalf or have any real transparency into how these technologies operate, managing and quantifying these trading costs in house is a real challenge. Below is a highlight from the Elkins/McSherry daily venue analysis which is scheduled to be released later this year. These venue analyses are attempting to highlight trading costs by venue, versus multiple benchmarks including: Arrival Price, Reversion and Spread Improvement as displayed below.

example of the spread improvement tCA display by shares & trade time shares per hour

Basis Points Basis Points

80000 70000 60000 50000 40000 30000 20000 10000 0

100 100 80 80 60 60 40 40 20 20 00 -20 -20

Improved Inside At Inferior Other 9:00

10:00

11:00

12:00

13:00

Venue 2

14:00

15:00

Low % of Price Improvement/ High Cost Venue

Venue 3

Venue 1 Venue 4

venue 11 Venue

venue 22 Venue

A r r iv aPrice l P r ic(BP) e (B P ) Arrival

venue 33 Venue

R e v e r s ioT+5 n T mins +5 m in s (B P ) Reversion (BP)

venue Venue44 P r ic eImprovement Im pr o v e m % e nt % Price

The next generation of trading cost analysis tools will allow money managers to provide non bias quantification of overall trading costs including, turnover rates, implementation shortfall, taxes/stamp duties, commissions and also enable clients to understand where their trades were executed and why. Forward-thinking money managers and brokers who embrace this type of transparency and openly provide clients with comprehensive trading cost analyses will experience increased investor inflows and superior growth. The marketplace is inviting transparency at all levels, which is highly evident from the growth of indexing and other transparent investment strategies. © 2012 Elkins McSherry LLC. All rights reserved. -2-

Vol. VIII, No 2

August 2012


Clients Demand Transparent Low Cost Investment Strategies More than ever investors are looking for transparent equity strategies that are well managed and easily understood. Trading cost analysis results typically add fuel to index growth as index portfolios are managed with much lower trading costs than active portfolios. The major driver of minimizing trading cost is turnover. At first glance it would appear the large savings derives from low program trading commission rates, however, clients are truly benefiting from reducing portfolio turnover. Active managers typically turn over their portfolio at five times the rate of passive managers. Regardless of the commission rate benefits passive portfolios achieve, taking our previously displayed example of a $10 billion active fund with 80% turnover, reducing these turnover rates from 80% to 15% will reduce the yearly trading costs from $32 million to just over $6 million, a savings of almost $26 million per year. Reinvested back into the market over a 30 year time horizon could amount to an additional $2.7 billion3 for fund participants. These staggering results clearly demonstrate the value of indexing and quantifying portfolio trading costs.

Emerging Market Equity Portfolios Benefit from Reducing Portfolio Turnover The US equity markets continue to be some of the lowest cost and efficient financial markets in the world. Despite all the recent criticism around high frequency trading, flash crashes and maker/taker venue models, the US maintains its stature as a low cost marketplace. Trading within emerging market countries can be more than twice as costly, than US equity trading. In addition, as stamp duties rise throughout the world this differential will remain. Currently 17 of 47 countries that Elkins/McSherry covers, requires a sizable stamp duty on equity trading. These stamp duties, combined with the slippage and spread costs incurred from FX markets heightens the potential costs of managing international equity portfolios. These potential costs are pushing investors to lower international equity turnover rates, increase the usage of ADRs and expand their allocations to indexing.

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Assuming a 7.5% total market return.


Vol. VIII, No 2

August 2012


The below chart highlights the 2Q12, average overall trading costs for the US4, Global5 and Emerging Markets6. Trading Costs (Commissions+Fees+Implementation Shortfall) TotalTotal Trading Costs (Commissions+Fees+Implementation Shortfall)

Basis Basis Points Points

100 100 80

US

60

Global Global

40

Emerging Markets Emerging Markets

20 0

2Q12 2Q12

Lowering Portfolio Turnover Rates May Improve Investment Performance Especially for Small Investors Since the advent of automation technology, the money management industry has witnessed a steady shift from manual investment processes to automated technology-driven portfolio management. The benefits of automation have provided investors with the ability to trade at dramatically lower commission rates. Although automation trading technology has been around since the early 1970s, it was not until 1975 when fixed commission rates were abolished that Wall Street would understand the true benefits of automation. A January 1975 $100,000 investment in the S&P 500 would be worth $5,832,720 today7. During the 37 years since May 1975, global equity investment returns have out-paced most other investment vehicles. Despite this tremendous performance, the general historic equity perception is negative as most investors have not fully participated in these long term gains, Investment fees, commission, trading costs and taxes have eaten into their portfolio returns. This negative perception is clearly evident in the most recent flows into the fixed income markets. The 10 year US Treasury yield is only 1.65% as of August 11 2012, yet we continue on a long-term government sponsored bull market in fixed income.

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5 6

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esults based on Elkins/McSherry trade cost analysis clients trading in US equities. These results include the costs of brokerage R commissions, fees and implementation shortfall. Results based on Elkins/McSherry clients trading in global equities. Results based on Elkins/McSherry clients trading within the emerging market countries of Argentina, Brazil, Chile, China, Columbia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Turkey and Venezuela. As of August 11th 2012 including dividend reinvestment. These results are not including any potential investment management or trading fees.


Vol. VIII, No 2

August 2012


What most investment analysts are missing is the vast improvements in efficiency that index equity investments are providing retail investors and the dramatic differences these efficiencies will have on long term participation in the equity markets. Historically, retail investors could anticipate equity rates of returns equal to earnings per share growth plus dividend growth minus investment costs and fees. As earnings per share and dividend growth rates are clearly unpredictable, the majority of focus should be on managing investments costs and fees. Although technology has substantially reduced investment costs for institutional investors, fees remain robust for most retail market participants. The average actively managed mutual fund contains fees ranging from 1% to 2% of assets, clearly a substantial hurdle for the “Main Street” investor. These fees, high commissions and the tendency of most investors to miss the best performing securities have prevented the majority of investors from reaping the tremendous rewards of the equity markets. Never before has there been a larger differential in costs from investment portfolios available in the marketplace. In addition to these substantial fees, retail investors are mostly in the dark on the negative impact of turnover, market impact and reversion on portfolio returns. Furthermore, as retail investment vehicles increase in size, these costs have potential to compound and create a continued negative drag on overall investment returns. As institutional investors are increasing their demand for transparency so too should retail market participants. As the overall investment marketplace becomes more transparent, investment costs are sure to decline, providing extensive benefits for the equity markets.
