UK government bonds have given investors a painful kick in the portfolio recently. Many of us found out bond funds are riskier than we realised. But with one simple(-ish) metric you can assess the riskiness of your bond assets ahead of any market crash. That metric is bond duration.

Quick note – Duration applies to bond funds, individual bonds, and portfolios of individual bonds. I’ll mostly just refer to ‘bonds’ throughout the article because it’s snappier. I’ll specifically call out bond funds when duration applies differently to them. Please check out our bond jargon buster for a brief refresher on confusing bond terminology.

What is bond duration?

Bond duration expresses a bond’s vulnerability to interest rate risk. The larger the bond duration number, the more reactive a bond’s price is to interest rate changes, as the bond’s yield adjusts to reflect those changes.

For example, if a bond’s duration number is 11, then it:

• Loses approximately 11% of its market value for every 1% rise in its yield1
  
• Gains approximately 11% for every 1% fall in its yield

Whatever your bond’s duration number2, that’s how big a gain or loss you can expect for every 1% move in its yield.

A duration three bond will rise or fall in value by approximately 3% if its yield moves by 1%.  

In a rising interest rate environment? Shorter duration bonds will be less risky than longer duration equivalents. But they won’t do much for you when rates fall. 

Conversely, long duration bonds are more comforting than your favourite teddy bear when interest rates fall. They go up in price!

But that would-be teddy bear is about as welcome as a grizzly at a picnic when interest rates rise. 

What affects bond duration? 

A bond’s time to maturity, yield, and coupon rate determine its duration:

Remaining time to maturity  

The more coupon payments a bond has yet to make until it matures, the more price-sensitive it is to interest rate changes.

That’s because a long-dated bond is stuck with its fixed interest advantage or disadvantage for many years in the future. A short-dated bond has only a few more payments due. 

• A distant maturity date implies a higher duration.
  
• A near-term maturity date implies a lower duration. 

Yield and / or coupon payment

Bonds with lower yields / coupon payments are more price-sensitive than similar types with higher yields / coupons. 

• A higher yield implies a shorter duration – because the bond returns your money at a faster rate.
  
• A lower yield implies a longer duration. 
  

The diagram below shows the tug-of-war that resolves a bond’s duration:

• Higher durations are primarily a function of longer bond maturities. Low bond yields / coupons also contribute. 
  

• Lower durations are primarily a function of shorter bond maturities. High bond yields / coupons also contribute. 

Higher durations equate to a more volatile bond price (up or down) when interest rates change.

Lower durations mean smaller price swings.   

All this helps explain why long duration bonds took horrible losses in 2022. As interest rates escalated, bonds trading in the market became less valuable.

Though it’s little comfort right now, duration also sheds light on why long bonds stepped up in value when interest rates plunged during the Global Financial Crisis. 

The ups and downs of being a bond

Bear in mind that duration is an approximate measure. It makes various simplifying assumptions about the relationship between interest rates, bond prices, and yields. 

But it helps to remember these opposing bond dynamics:

• When interest rates rise, bond prices fall. 
  
• When interest rates fall, bond prices rise.
  
• When bond prices fall, yields rise.
  
• When bond prices rise, yields fall.

Long bonds react more violently to these forces, for good or for ill. 

When interest rates rise, investors demand more compensation for tying up their money in bonds.

New bonds entering the market must have higher coupon payments to match the rate increase. 

But longer bonds are saddled with their old, lower, coupon payments for years – even decades. So their price falls to reflect their less competitive fixed rates. 

That price cut pushes the old bond’s yield up. It rises to the point where it’s just as attractive to a buyer as a new bond (of the same type) that waltzes in flashing its higher coupon payment. 

An analogy with cash savings accounts might help.

Let’s say you’re in the market for a fixed-rate savings account. Now suppose that interest rates had just risen from 3% to 4%. There’s no way you’d pick the same 3% account you might have gone for yesterday. At least not without a hefty bribe cashback offer. 

Bonds on sale

The discounted price of a less competitive bond is a bit like cashback given to new buyers to make it just as profitable as the new bonds they’d otherwise choose. 

In the savings business, banks withdraw old, fixed-interest accounts from the market. Existing savers, however, are stuck with their outmoded choice. Curses. 

With government bonds, debt obligations are seldom taken off the market. Instead they’re priced at a discount or premium to reflect their altered competitiveness, as interest rates yo-yo. 

Naturally, the process works in reverse, too. You earn a premium on bonds boasting a yield higher than prevailing interest rates.

Bond duration captures the short-term capital gain (price premium) or loss (price discount) part of these moves in one simple number. 

(Although even this this isn’t the end of the story. Counterintuitively, bond funds have higher expected returns after a price drop. That’s due to the impact of rising bond yields.)

How far do bond yields move? 

It’s all very well saying duration measures the price change sparked by a 1% yield move. But how far – and how fast – can bond yields bounce in the real world?

It’s the size and speed of your bond’s yield change that determines the scale of your capital loss or gain. 

Below is a snapshot of UK gilt yields, with changes in yield over the course of a day, month, and year: 

Source: Trading Economics.12 October 2022.

The daily, monthly, and annual shifts in yield shows you the impact of recent changes in market interest rates for each UK government bond in the table. 

You can see, for instance, that the yield (note: not the price) on the UK’s benchmark ten-year gilt rose 1.4% in the last month. In the last year the yield is up 3.5%. 

Indeed, every gilt with a maturity of three years or more saw its yield increase at least 1.35% in the last month, up to 3.8% over the past year. 

If you multiply shifts of that size by duration then that’s going to hurt. As every bond fund owner knows all too well in 2022!

Moving too fast

The duration calculation assumes instantaneous moves. But the longer the change actually takes to unfold, the less violent the price swing. Reinvested cashflows mitigate the impact. 

So it’s not quite right to multiply duration by real world movements that evolve over a year.

All the same, the size of the yield rises in the table above show us that just multiplying your bond’s duration by 1% doesn’t nearly capture the scale of the drama that can engulf us. 

Which bond is my bond fund like? – Compare your bond fund to individual bonds of the same type. Look up your fund’s weighted average maturity. It’ll behave similarly to an equivalent individual bond with approximately the same maturity. The yield-to-maturity of the fund and the bond should be pretty close. Do check the dates though. Published bond fund yields can be quite stale.

Bond duration: making your money back

There’s another aspect of bond duration which is much more debatable. 

This assertion is that your bond’s duration number tells you how many years it takes to recover from a capital loss after a yield rise – your breakeven point. 

Or, to put it another way: how long it will take to make the annualised returns you expected before rising yields put a dent in your portfolio. 

Let’s say you own a duration 11 bond fund, with a yield-to-maturity of 4%.

Interest rates go up, prices go down, and your bond’s value takes a hit.  

However, your bond fund fully makes up that lost ground by the 11 year mark. At that point, you’ve now earned a 4% annualised return over the entire period going back 11 years. The scar of the price drop has healed. It’s as if the interest rate rise never happened. 

Beyond 11 years, you’re up on the deal. That’s because your higher-yielding bonds pay you a better return than you would have received without the rate rise, when the yield would have remained lower.

All this assumes that your coupon payments and maturing bonds are reinvested.

The maths work the other way round, too.

If yields fall, then your bond return immediately jacks up (capital gain). But ultimately your returns soften like a tyre with a slow puncture. Beyond your duration number (expressed in years), you’re worse off over the whole period, because your cashflows are reinvested into lower-yielding bonds. 

The downgrade in return happens to a duration 3 bond after three years. A duration 11 bond has more staying power. It wouldn’t show a worse annualised return until 11 years passed. 

Here for the duration

All this is rule-of-thumb stuff. It works just fine for an individual bond that’s held until maturity, declining in duration as its coupons pay out. 

However ‘holding for the duration’ is less applicable to bond funds operating in the real world. 

In reality, bond funds turn over their holdings to keep the fund’s average maturity and duration relatively stable. The same goes for rolling portfolios of individual bonds. 

Moreover, interest rates don’t change course only once, and then remain static. They weave around like a drunk at a wedding reception. 

The traditional advice is to match your bond duration to your time horizon to ensure you get your money back. 

But that is based on assumptions that are about as realistic as diesel emissions tests. 

Indeed, there’s evidence to suggest you may have to wait for up to twice your bond fund’s initial duration in years to earn your initially expected yield-to-maturity. 

The twice duration rule-of-thumb

This rule of thumb says that twice your bond fund’s initial duration is a better guide to your breakeven point. 

Of course, you could earn your initially expected return faster if interest rates trend down and you enjoy a series of capital gain boosts. 

But when your holding period is dominated by rising rates then twice duration is a more pragmatic time horizon. 

This bracing finding comes from a research paper: Constant-Duration Bond Portfolios’ Initial (Rolling) Yield Forecasts Return Best at Twice Duration. The author is Gabriel A. Lozada, associate professor of economics at the University of Utah. 

A hat tip to Occam Investing. Occam pointed to Lozada’s research as part of a very good piece on bond returns.

The ‘twice duration’ paper specifically investigates the returns of bond portfolios held at constant durations. It employs a more realistic model for fluctuating interest rates than allowed for above. 

The author also empirically tested his model versus 60-years worth of historical returns. 

Lozada’s conclusion is you’re more likely to earn your initial yield-to-maturity over a twice duration timespan in a world where interest rates can go for a random walk, or trend upward for decades.

A better, not perfect, guide

Here’s the key finding for ordinary investors:

In summary, almost all the time, initial yield was within a percent or two of average annual realized return with a horizon of twice initial duration.

Are you a fellow glass-half-empty type? Then know this rule-of-thumb looks more rigorous than the happy-clappy ‘just hold for the duration’ advice of old.  

But the message isn’t that it will definitely take 22 years to earn say a 4% annualised return from a duration 11 bond fund. We’re not trapped by some boa constrictor of fate. 

If interest rates stayed relatively flat for the next eleven years, your bond’s yield would be about what you could expect. 

And if rates go down then you may earn more for a while. Though longer-term you’ll likely earn less. 

But given that interest rates are inherently unpredictable – and could relentlessly trend up – estimating that it could take somewhere between your bond fund’s duration and twice its duration to earn its yield is the hardheaded approach. 

Even then, this doesn’t tell you much about real returns.3

Other complicating factors

If inflation is higher than expected, nominal bonds do poorly. If inflation is lower than expected, nominal bonds do relatively well. 

It’s true too that if you pound-cost average into your bond fund then you’ll: 

• Shorten your path to higher overall returns in a rising rate environment 
  
• Shorten your path to worse overall returns in a falling rate environment 

Lozada says his findings apply to default-free bonds that aren’t callable (i.e. high-grade government bonds), but notes they aren’t a good fit for long bond portfolios.

Sometimes the best fit was 1.25 times duration or 1.75 times. Much depended on the type of bonds and the time period Lozada put under examination. 

Lozada also didn’t look at what happens if you periodically rebalance, withdraw cash, or spend interest. Or any other of the common investor behaviours that influence your particular outcome. 

Twice duration then is no more than a rule-of-thumb for short and intermediate government bond fund risk. Albeit a more steely-eyed (steely-thumbed?) one. 

If that doesn’t sound especially reassuring then check out the Banker On Wheels bond ETF calculator.

This suggests the twice duration rule should be reserved for gloomy scenarios when rates rise constantly during your time horizon. 

Duration and convexity

Duration simplifies the real world complexity of bond maths to broad strokes. Convexity fills in more of the detail. 

Convexity provides more accurate insights into bond price sensitivity because it accounts for the fact that yield changes also alter a bond’s duration.  

Picture the difference in price outcomes between the two measures like this:

The relationship between bond prices and yields is curved, whereas duration assumes it’s linear.

The practical outcome is:

• Duration (white line) tends to underestimate the bond price rise (green line) when yields fall. (Left-hand side of pic).
  
• Duration typically overestimates price drops when yields rise. (Right-hand side).

The difference between the green line and the white line reveals convexity at work. The convex curve of the bond price shows how it differs from the duration estimate as yields change.

When bonds exhibit positive convexity (as pictured above):

• Yield falls, price spikes, duration lengthens (duration underestimates actual price rise)
  
• Yields rise, price drops, duration shortens (duration overestimates actual price fall)

Essentially, the lower yields go, the faster bond prices accelerate versus duration’s estimate. 

Meanwhile, the higher yields float, the slower bond prices decline vs duration’s readout. 

Convexity amounts to a welcome tailwind. One that enhances your portfolio protection in a falling rate environment. And moderates expected bond damage in rising rate conditions. 

The effect is barely noticeable for short bonds. But is pronounced at extreme ends of the yield curve, as bond maturities head over 15 years until maturity. 

Portfolio Charts has produced some fantastic graphs that give you a proper feel for convexity. 

And we demonstrate convexity’s effects in our bond prices post. 

Incidentally, watch out for negative convexity. This occurs when bonds become less price sensitive as yields fall. (And vice versa). It’s the exact opposite of what you’d want to happen.  

Negative convexity is not a concern for default-free, non-callable government bonds. It is a worry if you stray into corporate / municipal bond territory where call options rear their heads. 

If convexity is more accurate then why does everyone use duration? Mainly because it’s simpler, but also because duration is good enough in most circumstances. 

Where to find bond duration numbers

A bond fund’s home page should tell you its duration number.

Though as usual, providers love to shower us with a confusion of different terms.

Average duration – A bond fund’s duration is the weighted average of the individual bond durations that it contains. So no cause for alarm if you see this label.

You can flip Vanguard’s site to the financial advisor view (wee dropdown menu, top-right, on desktop) to see its duration figures. For some unearthly reason you can’t see them on the consumer site.  

Modified duration – Strictly-speaking the correct term for the type of duration that measures price sensitivity to interest rate changes. Use this number where you see it. 

Effective duration – Modified duration diluted by the effect of any bonds with call options in the portfolio. Effective duration trumps modified duration if a fund gives you the choice. 

Use Trade Web to find out the modified duration for individual gilts. 

If you’d like to calculate bond duration then check out this calculator. 

Beware that duration doesn’t capture every dimension of bond risk. Credit quality is another major factor – and duration does not address this at all. 

Bond risk: higher or lower? 

As a Brucie Bonus, bond funds actually become less risky after the yield rises and the price falls.

I appreciate that’s in complete contrast to our instincts after big capital gains and losses. But the eagle-eyed might have noticed their own bond fund’s duration shorten following the recent falls.

For instance, here’s how the key numbers have moved for the SPDR’s intermediate gilt ETF (ticker: GLTY):

On 30 April 2020:

• Duration: 13.85 
• Yield-to-maturity: 0.35% 

On 30 September 2022:

• Duration: 10 
• Yield-to-maturity: 4.09% 

The fund’s yield is vastly improved while its lower duration number shows its price sensitivity is less volatile than a couple of years ago. 

The fund is now a better investment prospect than it was in 2020! But as ever after a big investment shock, some people will be too bruised to go back for more. 

Investing often defies our human intuitions. And bond investing perhaps most of all. 

Take it steady,

The Accumulator

PS – When we mention ‘interest rates’ in this post we’re referring to bond market interest rates, not central bank interest rates. References to ‘yield’ mean yield-to-maturity. Please see our bond jargon buster for more.

1. Yield to maturity. You can think of it like the interest rate you’ll get if you hold the bond to maturity. [↩]
2. Technically, it’s called ‘modified duration’. [↩]
3. Real returns subtract inflation from your investment results. In other words, they’re a more accurate portrayal of your capital growth in relation to purchasing power than standard nominal returns. [↩]

What caught my eye this week.

Another quiet week in British politics. And thank goodness for that. Maybe it’s time to recant?

After all, for the past six years I’ve been lamenting how the full-spectrum delusions of Brexit – the toxic campaigning, economic self-harm, and Alice in Wonderland contradictions – were causing real distress to both our economic prospects and our civil society.

How far from seeing a ‘Brexit dividend’ that politicians still had the gall to lie about with a straight face, our economy was weakened to the tune of £100bn in lost GDP a year.

How worst-case scenarios were inching towards the table that you wouldn’t want to wake up to in the morning.

But what a fuss about nothing!

Turns out there was – as my critics so often retorted – nothing to see here. Just a harmless bit of political roister-doistering, MPs implementing the will of the people, and Westminster ticking along as usual.

And how great is it to see our MPs hard at work with their heads down? Tackling the actually important issues like climate change and energy security, safe in the knowledge that we have crown stamps securely back on our pint glasses (thank heavens!)

The strong and steady hand of the Conservative party on the tiller, cleansed of its factionalism.

Our international credibility definitely just where it was in 2015.

So bad it’s good

Given the absolute 100% normality of British politics that vision-less, tofu-guzzling Remoaners like me have been squawking about for no good reason, let’s turn instead to the markets.

Because something interesting might be going on, unless my spidey senses deceive me.

Which, to be clear, they often do. No-one tingles – or times the market – perfectly.

But for those that do like a bit of speculation, it feels like we might be approaching the turning point in this fairly lengthy global bear market.

I began to think this a couple of weeks ago, when markets initially plunged on higher-than-expected US inflation but then turned around and ended higher.

True, things were choppy after that. But again this week there’s been a bounciness that’s hard to credit to the news flow – or even slightly less hawkish words from any given Fed official.

Don’t get me wrong. Equities are still going two steps forward and more or less two steps back.

But I’m seeing signs that investors are getting almost bored of bad news. That’s potentially a signal of a bear market bottoming, as is the fact that the kinds of shares that led the market lower have been more or less flat since summer.

Has everyone who is going to throw in the towel already let it go?

Rate expectations

It’s very hard to tell, always. Capitulation is one of those things you tend to see if you look for it – only for even more sellers to emerge from the sidelines when things get worse still.

For example – and to my embarrassment – I correctly noted growth stocks selling off late last year might presage a wider market decline.

But I also thought the apparently discarded disruptive stocks might now be an opportunity.

Oops!

Reader, I bought some. And some of that money halved or more.

I’ve also stubbornly stuck to the belief all year that most of the inflation around the world was caused by lockdowns rather than government handouts. Maybe in ten years we’ll have a perspective that shows that was right too. But the fact is we’ve laboured on with high inflation – and ever-higher rates – much longer than I for one thought likely.

That is the main reason why stocks have fallen so far.

But now – partly thanks to all those rate hikes – Wall Street sees inflation coming down steeply.

And while I’ve assumed since the summer that a big recession in the crucial US economy was the inevitable cost of raising rates so far and fast, the excellent macro-blogger at Calafia Beach Pundit offers plenty of evidence that things aren’t so bleak there either.

In other words, the rate hikes that drove the 2022 regime change might almost be done.

Perhaps by Christmas the Federal Reserve will be ready to pause?

Better yet, while rate rises definitely work with a lag so it’s too soon to be sure, the US economy might see a slowdown more than a slump. Which would be bullish for assets more generally.

Even the Bank of England took a moment out from supervising the kids to say it might not need to hike Bank Rate beyond 5%.

Darkest before the dawn

As ever, most people’s best response to all this will be to smile and say “that’s nice” and to keep on automatically investing into their balanced portfolios.

Maybe smiling extra hard on remembering that besides cheaper equities, you can also look forward to better returns from bonds to come, too.

Just don’t put all your eggs in a basket made in Britain. Just in case, you know, it gets a bit wobbly again.

Have a great weekend all.

[continue reading…]

Way back in 2018 regulators dragged another hidden cost beastie into the open. This festering colony of fee rot is collectively known as transaction costs. A swelling so big it’s like waking up to discover you’ve grown a second head. One with a hungry mouth to feed too. 

The ultraviolet light of regulation has revealed that transaction costs can increase a fund’s total charges by a third, half, double, or more. 

These fees aren’t new. We’ve always been paying them. But the industry has been curiously reluctant to come clean – even despite new rules coming into play. 

Currently, it’s like you agree to pay £15 for a streaming TV subscription – only for Disney or Netflix to swipe £30 on direct debit. Perhaps they hope you’ll never notice. 

The new disclosure regulations aimed to expose this subcutaneous fee fat. But you still won’t find transaction costs next to the Total Expense Ratio or Ongoing Charge Figure on a fund’s webpage. Nor in the Key Investor Information Document (KIID) or any factsheet. 

If you’re lucky they may lurk in an obscure PDF stuck in a corner of the provider’s website. 

Worse, many fund providers use loopholes to claim a negative transaction cost that makes their funds look cheaper than they actually are.

Industry insiders privately admit that negative transaction costs are absurd. 

It’s another investment industry mess that makes you realise you can trust them about as far as you can throw them. 

So the intent of today’s piece is to unravel:

• The quickest way to find transaction costs. Only then can you work out how much you’re really paying for funds (including ETFs and investment trusts).

• How to make the best use of those transaction figures coughed up by the industry. 

What are transaction costs? 

Transaction costs are the costs incurred through the buying and selling of a fund’s underlying assets. 

Transaction costs include:

• Explicit costs – broker commissions and transaction taxes
• Implicit costs – bid-offer spreads, market impacts and delays
• Other costs – namely stock lending charges
• Minus anti-dilution benefits

The following graphic lays out the transaction cost equation:

Explicit costs

Explicit costs are so-called because they involve measurable sums that are clearly paid to third-parties. 

Broker commissions are forked over for trade execution. These intermediary charges bundle up costs such as exchange fees, settlement fees, clearing fees, and administrative fees. 

Taxes include stamp duty in the UK plus other levies imposed by governments around the world on securities trading. 

Implicit costs

Implicit costs are indirect losses of value and are better thought of as market friction. They amount to a cost of trading when market prices move against a fund.

In contrast, market moves in a fund’s favour can be logged as negative transaction costs. And this is where the mischief creeps in. (See the ‘negative transaction costs’ section below). 

The bid-offer spread is the difference between the price market participants are willing to buy (bid) and the price they receive for selling (offer) the same security. 

Market impacts refer to the adverse price movements caused by the supply-and-demand effects of a fund’s own bulk trades. For example, a fund places a large order for a particular share. That very act bumps the share price slightly higher by the time the trade completes. 

Market makers are not obliged to make unlimited trades at their currently offered price. They can and do raise prices in the face of a big buy order, or lower them when a fund sells sizable lots. 

Large orders also attract the attention of other market participants. They can crowd the trade like ticket touts at a Rhianna gig. Agile operators may try to front-run the fund – buying the security first and pushing up its price.  

The ponderous fund then arrives like a flood of crazed superfans with wallets akimbo. This surge in demand raises prices further and front-runners make a nice little profit scalping the fund.  

Market delays: The more time it takes a fund to complete its order the further the price can move in the wrong direction.

Because large orders soak up market liquidity and bend the curve of supply and demand against the fund, managers try to lessen their impact by splitting a large trade into a stream of smaller orders. 

The hope is that the combined impact of the smaller trades is lower than one big splash.

This staggered order method takes longer, however. And the sum of trading by other market participants in the meantime can shift prices further against the fund than if the manager had just stormed in.

Yet the impact of market delay works both ways. So conversely, sometimes the price can swing in favour of a fund while its trade completes. For example, if the fund offloads shares while others are clamouring to buy, then each installment of its ‘sell’ order could gain a higher price than the last. 

Market delays are a rich seam of negative transaction costs when they net out in favour of a fund versus expected prices. The trick is to ‘expect’ a price that tilts the odds of booking negative transaction costs. 

Other costs

Stock lending costs are incurred by funds that use a lending agent to manage loans of their securities to short-sellers. 

Anti-dilution benefits reduce transaction costs

Anti-dilution benefits are designed to protect long-term investors from the love ‘em and leave ‘em antics of speculators, day traders, and financial gadflys like The Investor. 

Because fund inflows and outflows incur transaction charges – caused by the buying and selling of the underlying assets – they ‘dilute’ the value of existing / remaining investors’ holdings. 

Thus anti-dilution measures exist to make the traders pay, rather than the loyal investors who hold on through turbulence like a pantsdown politician’s supportive spouse. 

When a fund has separate buy and sell prices (known as dual-pricing) then the the bid-offer spread recoups the transaction costs of the churners.

But what happens when a fund is ‘single-priced’ (as with most OEIC type funds)?

Then the fund manager protects long-term investors via a levy or swing-pricing. 

The swing of things

A levy is a straight fee imposed on joiners and / or leavers. 

Swing-pricing, on the other hand, acts like a crypto-spread hidden beneath a fund’s single-price simplicity. 

• If buyers outnumber sellers then a fund manager can nudge the price of a fund upward. 
  
• Conversely if sellers exceed buyers then the price swings downward. 

The difference between the swing-price charged and the underlying market price of the fund’s assets allows the manager to offset transaction costs. 

Schroders published a nice visual to show how swing-pricing works:

The swing factor is the amount fund managers are allowed to move the price up or down from its mid-market price point. 

The adjusted price takes a bite out of buyers or sellers, depending on which group causes the fund to trade. 

(If inflows match outflows then sellers’ units can just be handed to buyers without incurring transaction costs.)

The anti-dilution gain is then deducted from a fund’s overall transaction costs. 

While the mechanism makes sense, canny managers can exploit anti-dilution calculations to create artificially large negative transaction costs.

What difference do transaction costs make to the price you pay?

Let’s consider some of the best value UK equity index trackers. Below you’ll see that transaction charges can more than double the cost of some:

UK large equity trackers	OCF (%)	Transaction cost (%)	Total cost (%)
Vanguard FTSE UK All Share Index Unit Trust	0.06	0.00	0.06
Fidelity Index UK Fund P	0.06	0.02	0.08
Lyxor Core UK Equity All Cap ETF	0.04	0.06	0.1
HSBC FTSE All Share Index Fund C	0.06	0.06	0.12
iShares UK Equity Index Fund D	0.05	0.11	0.16

Source: Author’s research

Intriguingly Vanguard’s FTSE UK All Share Index Unit Trust is currently showing a negative transaction cost of -0.01% on AJ Bell’s site. But its transaction cost was 0.05% in July, and 0.02% according to Vanguard’s cost and charges document dated February 2022.

I’ve zeroed out the fund’s negative transaction cost in line with FCA guidance. 

The situation is even worse among FTSE 100 ETFs: 

• HSBC FTSE 100 ETF: OCF 0.07% + transaction cost 0.25%
• Vanguard FTSE 100 ETF: OCF 0.09% + transaction cost 0.04%
• Lyxor FTSE 100 ETF: OCF 0.14% + transaction cost 0.69%

As you can see, the transaction costs differ wildly. They swamp the OCF in two cases.

Incidentally this isn’t just a problem for index trackers. Active funds typically have higher transaction costs than passive funds. 

Either way, relying purely on Ongoing Charge Figures is not good enough for dedicated cost cutters like us.

How to find fund transaction costs

The letter of the law enables fund providers to avoid revealing transaction costs in any helpful place – such as the charge’s section of a fund’s webpage. 

Some brokers clearly show transaction costs, however. 

AJ Bell has the most convenient tools I’ve found to quickly compare transaction charges. The links below enable you to rank:

• ETFs
• Funds (e.g. OEICs, Unit Trusts, and ICVCs1)
• Investment trusts 

Dial up the asset class or fund manager you want to assess. 

Tap on the Costs and Charges tab. 

You’ll see the investment’s transaction charge explicitly listed along with other fees that may apply. 

As far as index funds and ETFs are concerned, just tally up the Ongoing Cost figure (OCF) and the transaction fee to find the Total Cost of Ownership (TCO). 

This better estimates the true cost of your investment. Albeit all figures are backwards looking.

After you choose a fund, keep an eye on transaction costs for it and the rest of your shortlist. 

Check in perhaps once a quarter for the next year and take transaction cost readings for the funds you were considering. 

That’ll give you a handle on transaction cost variability and help decide which fund is the best value for money. 

Know thy enemy

What characterises funds that incur higher transaction costs?

They are likely to:

• Trade in illiquid markets
  
• Frequently buy and sell 
  
• Trade during volatile conditions
  
• Undergo large shifts in investment strategy
  
• Trade in securities with high commissions
  
• Rebalance frequently

The best global tracker funds are the antithesis of this. Consequently they sport very low transaction costs. 

Remember to always count negative transaction costs as zero. Don’t subtract them from your overall cost.

If a fund family consistently presents negative transaction costs then something is afoot. So I wouldn’t choose one of their products if zero or negative transaction costs are the decisive factor giving it an edge over its rivals. 

Indeed even the Financial Conduct Authority (FCA) says negative transaction costs are not to be trusted. 

Negative transaction costs

Negative transaction costs emerge when implicit cost calculations and anti-dilution benefits cancel out positive transaction costs and then some. 

Opportunities to game the system abound because the regulations allow fund managers to cherry pick from a range of methodologies that help tip them into negative transaction cost territory. 

That’s not to say that negative transaction costs are utterly bogus.

But they arise due to flaws in the calculus, not because a fund manager has a magic cost eraser.

As fund managers Schroders says: 

The most obvious manifestation of this is a negative transaction cost, which can be misleading as it implies that the manager has made money for the fund from the transaction, which is not the case as it is impossible.

The FCA is aware of the problem:

Incorrectly applying the PRIIPs requirements: some firms are incorrectly using the arrival price methodology when calculating transaction costs for primary issues. As a result, they are effectively crediting investment products with a negative transaction cost each time they subscribe to a new issue. They should instead be adjusting these to have no associated transaction cost, as per the ESMA Q&A. We are concerned that this practice may decrease the perceived cost of investing through an artificially reduced transaction cost figure.

Using the anti-dilution levy incorrectly: this tool should only be used to reduce dilution. However, we identified instances where its use is artificially reducing transaction costs at the expense of customers who subscribe into or redeem out of a product. In some cases, the levy applied is greater than the total explicit plus implicit trading costs. This more than offsets all transaction costs and results in an overall negative transaction cost figure.

Positive thinking

There’s plenty more evidence on why negative transaction costs occur. But I think we can let it rest there.

The FCA is reviewing the situation. Currently it mandates workplace defined contribution pensions should count negative transaction costs as zero. 

I see no reason not to cancel out all negative transaction costs, as even fund managers agree they’re not actually possible.

Transaction costs: cold bucket of reality or firehose of falsehood?

Clearly a well-meaning attempt to regulate the disclosure of transaction costs has been partially fumbled. 

Still, that’s no reason to stop rooting out transaction charges. They’re a performance drag every bit as serious as the other cost icebergs we look out for. 

Even in the ultra-competitive US market the key takeaway on transaction costs is (as identified by Larry Swedroe):

Trading costs of index funds are comparable in magnitude to expense ratios. 

The FCA places the blame squarely on nefarious fund managers who wriggle through loopholes for fun:

Our recently concluded review identifies that while most asset managers calculate transaction costs in accordance with the relevant rules, we found problems with the way some calculate transaction costs and how prominently and clearly they disclose them.

We conclude that asset managers may be communicating with their customers in a manner that is unfair, unclear or misleading and as such, investors can be confused and misled as to how much they are being charged.

Even when all costs are disclosed, they are still confusing: in instances where all related charges are made available, they are often disclosed in a way we believe requires unreasonable levels of effort from customers to both find and understand. They are commonly located in separate pages or documents on a firm’s website. This is especially concerning where these additional charges have a significant impact on the overall cost of investing and therefore a material effect on returns.

I’ll say! Such disinformation tactics would do Mr Putin proud.

The culprits knows that if they make finding the truth hard work then people will give up trying. 

Carrying on the good cost fight

I’m cheering on the FCA’s attempts to bring the miscreants to heel. In the meantime, we’ll update all our articles that rank funds by fees with transaction cost data just as soon as we can. 

In fact we’ve already made a start with our low-cost index funds and ETF piece. 

Take it steady,

The Accumulator

1. Investment Company with Variable Capital. [↩]