In an operationally efficient market, investors can obtain transaction services as cheaply as possible, given the costs associated with furnish- ing those services. Commissions are only part of the cost of transacting as we noted above. The other part is the dealer spread. Bid-ask spreads for bonds vary by type of bond. Other components of transaction costs are discussed below.
In an investment era where one-half of one percentage point can make a difference when an asset manager is compared against a performance benchmark, an important aspect of the investment process is the cost of implementing an investment strategy. Transaction costs are more than merely brokerage commissions—they consist of commissions, fees, execution costs, and opportunity costs.
Commissions are the fees paid to brokers to trade securities. Execution costs represent the difference between the execution price of a security and the price that would have existed in the absence of the trade. Execution costs can be further decomposed into market (or price) impact and market-timing costs. Market impact cost is the result of the bid-ask spread and a price concession extracted by dealers to mitigate their risk that an investor’s demand for liquidity is information-motivated. Market-timing cost arises when an adverse price movement of the security during the time of the transaction can be attributed in part to other activity in the security and is not the result of a particular transaction. Execution costs, then, are related to both the demand for liquidity and the trading activity on the trade date.
There is a distinction between information-motivated trades and informationless trades. Information-motivated trading occurs when investors believe they possess pertinent information not currently reflected in the security’s price. This style of trading tends to increase market impact because it emphasizes the speed of execution, or because the market maker believes a desired trade is driven by information and increases the bid-ask spread to provide some protection. It can involve the sale of one security in favor of another. Informationless trades are the result of either a reallocation of wealth or implementation of an investment strategy that utilizes only existing information. An example of the former is a pension fund’s decision to invest cash in the stock market. Other examples of informationless trades include portfolio rebalances, investment of new money, or liquidations. In these circumstances, the demand for liquidity alone should not lead the market maker to demand the significant price concessions associated with new information.
The problem with measuring execution costs is that the true mea- sure—which is the difference between the price of the security in the absence of the investor’s trade and the execution price—is not observable. Furthermore, the execution prices are dependent on supply and demand conditions at the margin. Thus, the execution price may be influenced by competitive traders who demand immediate execution, or other investors with similar motives for trading. This means that the execution price realized by an investor is the consequence of the structure of the market mechanism, the demand for liquidity by the marginal investor, and the competitive forces of investors with similar motivations for trading.
The cost of not transacting represents an opportunity cost. Opportunity costs may arise when a desired trade fails to be executed. This component of costs represents the difference in performance between an investor’s desired investment and the same investor’s actual investment after adjusting for execution costs, commissions, and fees. Opportunity costs have been characterized as the hidden cost of trading, and it has been suggested that the shortfall in performance of many actively managed portfolios is the consequence of failing to execute all desired trades.14 Measurement of opportunity costs is subject to the same problems as measurement of execution costs. The true measure of opportunity cost depends on knowing what the performance of a security would have been if all desired trades had been executed at the desired time across an investment horizon. As these are the desired trades that the investor could not execute, the benchmark is inherently unobservable
Posts Tagged ‘Risk’
Operational Efficiency
Wednesday, September 1st, 2010Absolute Returns: Risk Reduction
Friday, July 3rd, 2009Just as a corporation has to decide whether to run their Treasury operation as a profit or as a loss reducing centre, so a portfolio manager has to make the same choice in the approach they take to managing currency risk. If a portfolio manager is focused on maximizing absolute returns, the emphasis in managing their currency risk is likely to be on risk reduction. In order to achieve this, they will most likely adopt a strategy of passive currency management. This involves adopting and sticking religiously to a currency hedging strategy, rolling those hedges during the lifetime of the underlying investment. The two obvious ways of establishing a passive hedging strategy are:
Three-month forward (rolled continuously)
Three-month at-the-money forward call (rolled continuously)
The advantage of passive currency management is that it reduces or eliminates the currency risk (depending on whether the benchmark is fully or partially hedged). The disadvantage is that it does not incorporate any flexibility and therefore cannot respond to changes in market dynamics and conditions. The emphasis on risk reduction within a passive currency management style deals with the basic idea that the portfolio’s return in the base currency is equal to: The return of foreign assets invested in + the return of the foreign currency
This is a simple, but hopefully effective way of expressing the view that there are two separate and distinct risks present within the decision to invest outside of the base currency. The motive of risk reduction is therefore to hedge to whatever extent decided upon the return of the foreign currency.