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 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 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.
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|
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:
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.
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,
- Investment Company with Variable Capital. [↩]