Transaction cost debate: where to next?

First published in Pension Funds Online, 09 June 2017

The asset management industry is not used to having the spotlight shone on it, however it has come as a result of the debate on costs and charges. Donny Hay looks at the importance of transparency when dealing with costs.

In her January 2017 article titled "Understanding the transaction cost debate" my colleague Alison Bostock asked how DC trustees and Investment Governance Committees (IGCs) can meet their duty to assess whether transaction costs are value for money.

The debate has moved on and now is the opportunity for the asset managers to step up to the plate.

And this matters. The FT recently reported that USA companies and asset managers have paid out $400m in litigation settlements due to oversized fees and charges.

The conclusion there was that very little attention was being paid to making sure fees were reasonable. 

Why do transaction costs matter? While the asset management charge and total expense ratio are generally easy for investors to identify and understand, transaction costs are largely hidden.

However, research and experience show that these costs can often be over 50% of total portfolio costs and upwards of 50bp. And each 0.50% cost on a 4% annual return reduces a DC member's portfolio value by 20% over 20 years.

Regulatory developments

There is not a common standard for measuring transaction costs. The FCA has proposed the 'slippage cost' method which seeks to capture the whole cost of the trade, including the market movement aspect.

This simplistic approach has been criticised by asset managers and others as that market movement can outweigh all the other costs.

This can be confusing as the cost could be negative, e.g. if buying securities in a falling market. The Investment Association is taking a different tack and favours using the 'spread' method which combines portfolio turnover with an estimate of the transaction costs incurred.

This effectively calculates a swing price or dilution levy that ensures existing investors are no worse off as a result of inflows and outflows from the fund. Managers already use this approach in their unit pricing systems for pooled vehicles so the information is more readily available. We await the recommendations of both bodies over the summer. 

At the same time the DWP is considering whether transaction costs should be included within the charge cap of 0.75%.

The problem

So much is happening, so much change; a case for inertia if ever I saw one. Some regulatory standards include transactions costs, others don't; there are different calculation methods and even the nature and type of costs included can be different, making it all doubly confusing for investors. 

The principle underlying these changes is that transparent information leads to better decision making. This makes sense, but more consistency and clarity is needed. 

To compound things, the treatment of costs varies between asset managers. For example in stock lending, where managers will take different portions of the revenues to run this activity.

Not all charges are borne by the fund, in some cases the asset manager will pay for part of the cost. Some costs are difficult to detect or measure, e.g. the level of look through when investing in external funds, or the carry cost within private equity investments.

Looking forward

So, understanding transaction costs is a complex area for investors. Different asset managers will approach costs in different ways making it hard for investors to assess value for money. 

Also, it's not just about the number. Higher costs are not necessarily bad, but there also needs to be an assessment of the value added, e.g. we know active costs more than passive.

We don't want the focus on costs to be at the expense of returns and better outcomes for members, and trustees need help in making these judgements.

So as we await the recommendations of the regulatory and industry bodies, we should remember that transparency and assessment of the control environment that surround these costs is as important as the cost itself.

Written by Donny Hay, Client Director at PTL.

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