When they select a manager to whom they delegate an investment, most institutional investors pay only scant regard to the question of transaction costs. It is true that in terms of differences in administration costs or the total expense ratio, it is not really possible to compare one fund with another using a standardised indicator, apart from portfolio turnover rate, which only provides an approximation. However, the performance of a fund is not completely unrelated to this parameter: with increased volatility, the cost of executing an order on the stock markets of developed countries has increased significantly, today nearing 50 basis points according to a number of trading desk managers at leading fund management companies. In other words, execution costs are up to five times higher than the 10 basis points for brokerage fees. Overall execution costs include fees actually paid, called explicit costs, covering commissions paid to the broker to access the market, and the costs of post-transaction services, including implicit costs, which do not generate an actual expense but appear in the execution price. This latter category includes the difference between the price offered and the price requested (the bid-ask spread), the impact of the order on the stock price and slippage resulting from the time required to execute the order.

Best execution

While the question of transaction costs fails to significantly arouse investors’ curiosity, it is partly due to the coming into force of the Markets in Financial Instruments Directive (MiFID), which has been a major factor in distracting them from the issue by imposing on fund management companies an obligation of best execution, aimed at providing the end investor with a guaranteed outcome. "Our response to the obligation of best execution has been the introduction of an execution desk since 2009," says Patrice Robert, trading manager at Groupama AM. "We now have execution specialists and have introduced tools to optimise the order process and to monitor execution."

From the institutional investor’s point of view, investments under fund management are accompanied by new turnover commissions. Specialisation in execution is also a response to the complexity created by the opening up to competition of trading venues, which has encouraged the emergence alongside the regulated markets of alternative trading platforms (MTFs, or multilateral trading facilities), of dark pools and crossing networks. The increase in trading venues has also created numerous arbitrage possibilities for the execution of transactions and the necessity for a manager or broker to be capable of exploiting these opportunities.

A survey by Oxera commissioned by the European Commission highlights a significant spread in access costs to the various platforms. In particular, access costs invoiced for a transaction of British shares in 2009 ranged from 0.03 to 0.30 Euros. This observation also holds true for implicit costs, with liquidity being dispersed between the different execution venues. "By performing a post-analysis of execution quality, we note that there are brokers who do not have access to all the liquid pools or those who are late establishing their connectivity. This is reflected in the level of the execution price," states Eric Heleine, a share trader at Groupama AM.

Algorithmic transactions

Specialisation by fund managers in transaction execution came about when lower costs promised by MiFID were generally failing to materialise. While the Oxera survey revealed a lowering of trading platform utilisation costs by an average of 60%, the average commission invoiced by brokers fell by only 21% between 2006 and 2009 or from 9 to 7 basis points. "These figures mask significant variations in reductions observed in financial venues. Furthermore, some of the drop can be attributed to the decoupling of services not associated with execution, such as research, which are no longer paid for through a commission rate invoiced for the execution of the transaction," the survey notes.

According to the latest survey by Greenwich Associates, average commission rates even remained stable over the 2007-2011 period, varying between 9 and 11 basis points. However, the spread amongst fund management companies of algorithmic type order execution should encourage a lowering of costs. "Verbal orders have commission rates of between 6 and 15 points, against 5 basis points or less for algorithmic orders," says David Angel, CEO of ITG in France. With the anticipated expansion in algorithmic trading, which according to forecasts by Greenwich Associates will reach 20% of transactions by 2014 (as opposed to 14% today and 5% in 2007), lower transaction costs might become more palpable in the future. This development is also likely to reduce implicit costs by reducing order size and thereby the potential impact on the price of the stock. The Oxera survey also mentions a significant reduction in the average transaction size, from 25,000 euros in 2006 to 10,000 euros in 2009, but the inherent positive effects of this development are currently being masked by the increase in volatility in the financial markets, which has an upward influence on implicit costs. According to an indicator developed by UBS, they currently amount to approximately 40 basis points for transactions taking place in stock markets in developed countries.

Currency transactions

Although it currently remains difficult to quantify the lowering of transaction costs associated with MiFID, it can nevertheless be stated that the European legislative framework has structured the way European fund management companies execute their orders on stock markets. Conversely, other market areas not covered by the scope of the Directive have seen spin-off effects. Dysfunctions in terms of the execution of currency transactions have been highlighted by complaints by large American pension funds against two custodians, State Street and BNY Mellon, accused of overcharging for currency transactions entrusted to them for years. The issue was also discussed in a recent report by the Bank of Norway: "The spread amongst currency transactions performed by custodians is between 30 and 40 basis points wider than interbank spreads," the report states. "This observation is associated with the relative opacity that dominates these transactions. When a fund manager asks his custodian to buy or sell a foreign asset, the order is generally accompanied by an instruction for the currency transaction. Consequently, the custodian’s clients receive very little information about the transaction. They only become aware of the actual rate used after a period of several days, or even weeks, and have no information about the exact time of the transaction and the effective price spread."

As a result, the report mentions that institutional investors have become more attentive to the execution of currency transactions, more systematically analysing the costs of this type of transaction. The results of an audit performed by a European pension fund, one to which bfinance was privy, tend to confirm such observations. Transactions performed on behalf of this investor throughout 2010 show a far worse average rate than the average weighted rate for all transactions over the period. Furthermore, exchange rates used are nearly always amongst the lowest observed on each day of pricing. "When they do not use dedicated electronic platforms, asset managers make use of their custodians for currency transactions," notes Angel. Asked about this issue, one manager tells us that rates are indeed "a little high", specifying that the use of custodians mainly takes place for transactions involving small amounts. "Also, there are more and more managers who are now monitoring the quality of these transactions," confirms Angel. Such monitoring could grow with the current MiFID reforms, one objective of which is to extend the principle of best execution to all asset classes. In the meantime, investors are able to improve the execution of their currency transactions by setting up service delegation agreements which define the principles of best execution by centralising all transactions with a single party for netting purposes or by regularly auditing these transactions.

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