Why it is crucial to get a handle on transaction costs

All members of DC schemes require transparent and consistent information on their investment choices in order to make informed decisions. 

Investors should know exactly what costs they can expect to incur when they invest in a fund.

It is hard to argue with this logic; most people would not purchase a house without viewing it first and knowing what its running costs were.

One of the most opaque and misunderstood costs incurred by investors are transaction costs.

The various components of transaction costs vary between asset classes, which makes it difficult to draw fair comparisons.

However, the end investor requires understandable, consistent and comparable information with which to make their choices. Transaction cost disclosures from fund providers often fail to meet these criteria.

Dutch experience

The Financial Conduct Authority, together with the Department for Work and Pensions, has begun to tackle the transparency issue in the UK with a consultation to investigate this particularly thorny area.

If there is to be full and fair disclosure, any report must include all transaction costs.

The Dutch have recognised that calculation of certain implicit costs is very difficult, and have instead produced a standardised set of transaction cost estimates that must be used where actual costs are unknown

This is relatively simple for known cash costs such as broker commission and taxes. However, costs such as bid/offer spreads, market impact and opportunity cost are far from easy to calculate.

The fundamental structure of some of the markets themselves, in particular fixed income, do not lend themselves to capturing the actual cost at the point of trade.

The experience of the Dutch pensions market, which requires pension funds to report all the transaction costs they incur, may well highlight a possible solution.

The Dutch have recognised that calculation of certain implicit costs is very difficult, and have instead produced a standardised set of transaction cost estimates that must be used where actual costs are unknown.

Future legislation needs to be carefully designed to avoid unintended consequences.

For example, investment strategies come in many different forms, and high transaction costs do not necessarily mean that the underlying strategy is a poor one.

Some funds’ investment strategies incorporate a relatively high level of turnover, as positions are held for short periods of time before being traded into a different position, which could lead to higher reported transaction costs.

This is an inherent, intended component of the specific investment strategy. Ultimately the performance return net of all costs is of greatest importance to investors.  

Increased scrutiny

In the drive for greater transparency on costs, we must not lose sight of the needs and level of understanding of the end user.

Too much, or excessively complex, information may become off-putting and prevent people from saving and investing due to a perception of costs being too high, or picking sub-standard funds because they are cheap.

What is not up for debate is the fact that transaction costs are going to come under greater scrutiny in the future.

Whether it is an investment manager reporting costs to an investment committee, or a trustee body reporting costs to its scheme membership, the industry needs to develop a greater understanding of transaction costs.

Full disclosure of costs may not be achievable in the short term, but the government, the regulator and the industry as a whole will need to work closely together to ensure consumers understand exactly what they are buying.

Andrew Williams is principal at Mercer Investment Consulting