Transaction Cost Research

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Introduction

New technologies, such as utilizing algorithms and straight-through processing, result from the drive to lower transaction costs, as well as the associated research involved behind each execution. According to the TABB Group, Transaction Cost Research (TCR) is defined as the amount of money spent to open a new position or to close an existing position. Transaction cost analysis started with fulfilling regulatory requirements. It can significantly drag performance, especially for portfolio strategies that include high turnover. All transactions have explicit and implicit costs. Explicit costs are disclosed prior to the trade and include commissions, markups, and other fees.

Implicit costs represent the costs that are not determined until after the execution of a trade or set of trades is completed. TCR can be defined as the movement of the stock price from the time of the investment decision to the expiration or completion of the order. Minimizing implicit cost is a key factor in gauging execution quality. Commissions are generated through trade execution; however, commissions fund multiple services, which include execution, research, conferences, and technology. Transaction costs affect investors, pension plans, money managers, and broker-dealers. These costs are ultimately passed on to the investor. TCR includes the measurement of transaction costs after the trade is executed (post-trade) as well as expected costs before the order is placed (pre-trade). 1 As investment management becomes increasingly competitive, portfolio managers will look for methods of enhancing their returns through lower transaction costs to boost their overall rate of return. On the contrary, broker-dealers and the sell side will try to adapt and continue to service the investment community through lowering commissions and transaction costs by routing executions via electronic venues such as direct market access (DMA) or algorithms (see Exhibit 10.1).

Brokers are under enormous pressure to reduce brokerage commissions. This has caused profit margins to fall, and research costs become increasingly paid for by the broker. The push by the buy side to segment commissions and transaction costs between research and trading led to Fidelity’s landmark deal with Lehman Brothers. Fidelity agreed to pay approximately $7 million USD annually for research and approximately 0.02–0.025 cents per share for execution services. Large buy-side investment managers such as Fidelity already have their own research staff, and would most likely put further pressure to segment and lower sell-side research and trading costs with other broker-dealers. Some money managers pay for research out of their own pocket (hard dollars) and receive lower commission costs, translating to higher management fees. Other investment managers may combine research and execution commissions paying higher rates. Firms with limited research needs may use DMA and algorithms. Electronic and algorithmic trading has been one avenue that has helped sell-side firms to retain order flow and lower transaction costs, but they lack a solid method of retaining relationships with the investment community. ...