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Transaction costs explained

Often reported as ‘hidden’ charges and largely unknown to many investors, transaction costs are inflating fees for some to over double the headline rate

TABLE OF CONTENTS
  • What are transaction costs?
  • How are they reported?
  • How do they affect returns?
  • How can I evaluate them?
Important Note

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The value of investments, and the income from them, can go down as well as up, so you may get back less than you invest.

What are transaction costs?

Transaction costs are incurred when making an economic transaction, such as buying or selling shares. The process of investing is not frictionless and creates cost.

They come about for one of two reasons, some represent actual payments required to complete a transaction, and some represent value that is lost to the market during the process of buying and selling.

Actual payment transaction costs are paid to other entities, such as a transaction tax that is paid to the government, or commission that is paid to a broker.

Transaction costs that represent value lost to the market infrastructure include the bid-offer spread, where shares are priced differently depending on whether you are buying or selling.

Fund transaction costs are not a source of income for fund management companies, but are instead a necessary part of the investing process. Funds incur transaction costs and pass them through to investors.

No longer ‘hidden’ from personal investors

Transaction costs are sometimes reported as ‘hidden’ charges - they were largely unknown to personal investors before 2018 when new European legislation known as Mifid II came into force, which requires funds to publish a full list of their costs.

Since then, investors have been able to see all ongoing costs associated with being invested in a fund, including how much the transactions cost in total.

Types of transactions that incur costs

Funds transact when either

  • The manager chooses to buy or sell to change the fund’s composition, for example, if an index tracker fund is rebalancing to reflect changes in the underlying index
  • Investors buy into or leave the fund, increasing or decreasing the total fund size, and the fund manager needs to buy or sell shares to resize the fund

It seems unfair that investors should suffer increased transaction costs because of others moving into or out of the fund. To protect existing shareholders from bearing these costs, many funds use anti-dilution mechanisms.

Anti-Dilution Mechanisms

Traditional mutual funds often use a method of anti-dilution protection called swing pricing.

With swing pricing, the fund manager adjusts (‘swings’) the price of the fund away from the value of the underlying assets - investors coming into or leaving the fund pay the swung price and the difference is used to offset any transaction costs.

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ETFs are freely traded on an exchange - the manager has no control over fund pricing and so cannot use swing pricing. Instead, when wanting to create new shares of an ETF, the manager turns to another market participant and request they purchase the underlying shares or bonds in exchange for shares of the ETF.

The purchaser can then sell the newly acquired ETF shares when the market price is sufficient to cover any transaction costs incurred from buying the shares or bonds.

How are transaction costs reported?

Investing platforms often highlight the ongoing costs associated with being invested in a fund - usually reported as a Total Expense Ratio (TER) or Ongoing Charges Figure (OCF) – but these do not include transaction costs.

The TER and OCF are measures of the total costs associated with managing and operating an investment fund and include the fund manager's annual fees and some other expenses such as depositary, registrar, accountancy, auditor, and legal fees.

Bundling transaction costs in the TER or OCF wouldn’t make sense as firms are allowed to use different calculation methodologies for transaction costs – this also means you can’t directly compare them between providers.

Where are transaction costs reported?

Transaction costs are reported in the annual reports of funds. Some providers, such as Vanguard, provide a separate cost summary document that includes a transaction cost figure for each fund.

Some online platforms, such as Fidelity, display transaction cost data in their fund comparison tables, which is often provided by a financial data provider such as Morningstar.

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In the past some fund managers have changed their transaction cost calculation methodology which can affect historic trend analysis.

Differing methodologies

The difficulty in calculating transaction costs is capturing the total value that is lost due to market infrastructure, such as through the bid-offer spread. Different calculation methods are permitted within the regulations and differing opinions as to which one is best.

Some funds also have anti-dilution mechanisms, such as swing pricing, which result in transaction cost adjustments to reflect the protections provided to investors. These are expressed as a negative transaction cost adjustment which creates complications when considering how to reflect total transaction costs for a fund.

Dilution adjustments can, in some cases, offset all other transaction costs. A low total transaction cost figure may not be the result of fewer transactions but rather a particularly large dilution adjustment.

How do transaction costs affect returns

Transaction fees can increase the total cost of investing in a fund far beyond the OCF/TER rate. They are particularly important for index trackers funds, where cost minimisation is a priority for investors as even the smallest difference can be a major hit to long-term returns.

Across ten of the most popular funds that track either the FTSE 100, 250 or All-Share, investors are paying on average 85 per cent more in additional transaction cost fees above the headline charge rate.[1]

The fund's return net of costs is what matters most, and this will depend on the types of assets in the fund, market conditions and ongoing charges including transaction costs.

What causes transaction costs to vary

Transaction costs vary over time, from country to country, and depending on the types of assets.

Generally, it costs more to trade shares of smaller companies and in less developed economies. Fixed costs, such as the amount spent on commission, are generally lower in more developed countries and when trading in the shares of larger companies. Market friction is also lower for these types of shares, with smaller bid-offer spreads reducing the amount lost to the market infrastructure.

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For tracker funds, if the underlying index changes frequently then a fund will have to transact more to match the index changes. In general, indexes made up of stable mature companies are less likely to change compared to indexes of smaller fast-growing or emerging market companies.

For actively managed funds, the fund manager will decide how frequently to trade, and this will directly affect the level of transaction costs.

How can I evaluate transaction costs?

Transaction costs need to be seen within a broader context that considers the fund type and market conditions. For example, transaction costs may be higher for a fund buying shares of smaller companies, but these costs could be “priced in” to the shares as higher expected returns. Equally, transaction costs may seem high for a particular fund, but this could be due to changes in general market conditions.

Transaction cost calculation methodologies differ between providers, so you can't make direct comparisons between them. Broader analysis of trends and averages across different market sectors can provide investors with a fuller picture of potential investments.

FTSE 250 example

The FTSE 250, an index consisting of the 101st to the 350th largest companies listed on the London Stock Exchange, has transaction costs that are on average higher than the FTSE 100 (which is made up of the 100 largest companies).

Four of the most popular FTSE 100 funds have transaction costs averaging 0.09%, which is under half the 0.20% average for three of the most popular FTSE 250 funds.[2]

Trackers for market weighted indexes such as the FTSE 100 and FTSE 250 do not have to buy and sell shares to reflect movements in the index, except when companies enter or leave or because of corporate actions.

When companies move into the FTSE 250 – either by entering at the bottom or from the FTSE 100 at the top - trackers that follow the index need to buy and sell shares to reflect the changes. In theory, if a share moves from the FTSE 100 down into the FTSE 250, a FTSE 250 fund must sell it's largest holding and replace it with shares of the new company.

Transaction costs are in general lower for larger companies, such as those found in the FTSE 100, when compared to smaller or medium sized companies.

An investor looking specifically to invest in shares found in the FTSE 250 may decide to invest in a fund that tracks the index. However, others looking for broad UK exposure could decide to target a broader index like the FTSE 350 or FTSE All-Share, in an effort to reduce cost.

1 ETFs and Traditional Funds by HSBC, Vanguard and SSGA. Based on Morningstar transaction cost data as at September 2021

2 FTSE 100 and FTSE 250 ETFs and Traditional Funds provided by HSBC AM and Vanguard. Based on Morningstar transaction cost data as at September 2021

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