In days of yore, navigational maps were often illustrated with dragons and sea monsters, indicating that danger was afoot on the high seas. The imagery may have been mythical, but the risks were real enough, especially for travelers who failed to equip themselves for the journey. To this day, risk and reward remain tightly connected for those venturing into our global markets. In seeking market returns, we must equip ourselves with reason and evidence, separating fact from fiction to tackle the real dangers that lie in wait. Hidden trading cost is one such elusive but formidable foe.
Trading Costs: Now You See Them, But Sometimes You Don’t
Some investment expenses are easier to spot than others. For example, a fund’s expense ratio must be disclosed in its prospectus, and when you buy or sell shares of a security you should see a brokerage fee appear in your trade confirmation statement. You may or may not take the time to scrutinize these costs, but at least they are in plain sight. (In fact, if these sorts of costs are not readily disclosed, that is a red flag in and of itself.)
Then there’s the assortment of trading costs that are not as apparent as directly reported expenses. In the financial professional and academic communities, these are sometimes referred to as “friction costs” – invisible forces that drag unseen against your portfolio returns.
The Hidden Damage Done
If we can’t directly see hidden costs, how do we know they are there? Similar to the way physicists study gravity, capital market researchers seek to measure hidden costs by observing the effect they have on what can be more readily seen: the end returns you receive from your investment, compared to other, similar kinds of investments.
For example, imagine you are comparing paints for your home renovation project. Brand A and Brand B both cost $25/gallon. At first, it may seem there’s no difference in price. But what if you learned that you’d need two coats of Brand A to achieve the same coverage that Brand B provides in one coat? By observing the end results of this hidden cost, it’s easy to see it showing up as real dollars spent from your wallet.
Studies have indicated that hidden costs can add up in significant ways as well. “Shedding Light on ‘Invisible’ Costs” is one such piece, published in the January/February 2013 Financial Analysts Journal. According to the paper’s abstract (emphasis is our own), “The authors found that funds’ annual trading costs are, on average, higher than their expense ratio and negatively affect performance.” A report on the same study posted by the UC-Davis Graduate School of Management noted, “Funds’ average annual expenditures on trading costs (i.e., aggregate trading cost) were 1.44% compared to their expense ratio of 1.19%. And there was considerably more variation in fund trading costs than in expense ratios.”
How To Slay a Dragon: Step One, Spot the Dragon
Hidden trading costs can be difficult to combat; they are by definition elusively observed and slippery to measure. Most investors are unaware they even exist. So the first step in minimizing them is to familiarize yourself with them. Some of the more notorious friction costs include bid-ask spreads, market-moving costs and opportunity costs.
Bid-ask spreads are the difference between the highest price a buyer wants to pay for a security (the bid) and the lowest price a seller wants to accept (the ask). For example, if a buyer hopes to purchase a security for $10/share but the seller hopes to receive $11/share, the bid-ask spread is $1. Whoever “loses” in the transaction by selling for less or paying more than desired incurs a hidden cost; they are essentially starting out $1 behind on the end return they were seeking to receive.
If you, as in individual investor, decide to sell or buy 50 shares of Whizco stock today, the current price will be the price at which you trade all 50 shares. The rules change when a major market player such as an institution or mutual fund seeks to rapidly trade enormous blocks. In a classic case of supply and demand, when the market notices a trader who is anxious to buy or sell large lots, it reacts by temporarily moving the supply price up or down and widening the bid-ask spread against the demanding trader. This generates market-moving costs before the trading is completed. For example, index funds face market-moving costs when they must rapidly buy or sell positions after their underlying indices reconstitute. They end up paying more for their buys and receiving less for their sells than would otherwise be expected.
Market Opportunity Costs (Moving to Cash)
In the broadest sense, opportunity costs are incurred when you commit to one opportunity that is less desirable than another. In investing, it means committing your assets to one strategy when another would have offered better results, given your particular goals. The cost is the difference between the value of the position you took versus the one you could have had instead.
The academic evidence on the factors that drive long-term market returns informs us that a highly efficient way to participate in the market is to simply be there: patiently, globally diversified, cost-effectively, capturing expected returns when and where available, according to individual risk tolerances. In the absence of this sort of disciplined strategy, it’s easy to forever torment yourself by considering every “opportunity” the markets make available. Fund managers aren’t immune to this same angst, which is why significant market opportunity costs can occur when they disregard this body of evidence and instead seek to second-guess the market, moving to cash when markets turn volatile and trying to predict when it’s time to move back in.
In his classic, “Common Sense on Mutual Funds,” Vanguard Group founder John Bogle explains: “The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”
Combating Hidden Costs: Our Role as Your Advisor
Now that you have familiarized yourself with these hidden costs, how should you proceed? As an investor, your goal is to seek investment advisors who are best positioned to:
Cost-conscious advisors demonstrate the following characteristics:
Following a disciplined investment strategy built on lower cost investment vehicles comes naturally to us at Dowling & Yahnke, LLC. Combating hidden costs is part of our fiduciary obligation to serve your highest financial interests, and one of many ways we feel we handily offset our own, fully transparent advisory fees.