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Measuring Transaction Costs

Tracking error. Slippage. Transaction costs. Trading costs are where the rubber hits the road. These expenses are often the difference between pretty pictures and making money from a quantitative investment strategy.

Most professional trading desks, particularly those involved in trading baskets of stocks, have some model to estimate and measure transaction costs. Closer to home, a detailed analysis of total trading cost reveals that individual investors enjoy a huge advantage in trading costs relative to professionals.

Several quant shops have developed commercially available products for measuring transaction costs, including Abel-Noser, Plexus, BARRA, Salomon Brothers, Merrill Lynch and, most recently, Donaldson Lufkin & Jenrette. In every instance, the models have found that commission cost was the smallest variable contributing to total transaction cost. Market impact, measured in various ways, was always significantly larger than commissions.

Market impact is basically the difference between the price quote prior to the trade's initiation and the price at which the trade is filled. Abel-Noser, which was the first brokerage firm to offer a trading cost product, compares each day's average cost with the value-weighted average price for the stock during the day. More appropriately for large institutional orders, many of the commercially available products track the trade's cost over a series of days as the trading desk works the order. Plexus starts a little earlier in tracking the trade process, starting from the portfolio manager's initial decision, then tracking the trade over time until it's complete.

BARRA notes that any measure of trading cost will be greatly underestimated because of the tendency of portfolio managers to submit trades in a realistic fashion. Portfolio managers want their trades to be filled, so most large orders are naturally for large-cap, liquid names. The opportunity costs associated with such self-censorship are substantial.

Investors managing less than $3 million in assets, on the other hand, can establish a meaningful investment position in small, illiquid names relatively quickly. Why do individual investors focus on smaller stocks than the pros? Because they can.

A model developed recently by DLJ adds an interesting and useful twist to the measurement of market impact by splitting the cost into two portions -- the direct impact from the trade and an implied cost associated with the time the trade takes to complete. In a study of billions of dollars of transactions, DLJ found that the timing cost was six times more significant than the direct market impact cost. Specifically, the cost of commissions plus direct market impact was $0.05 per share, while the cost of delay in filling the order was $0.30 per share.

I see this as an exciting finding, because it highlights the advantage enjoyed by individual investors in regards to overall trading costs. Because of the integration of the small order execution system (SOES) into the online brokerage trading mechanism, individual investors can usually get a transaction filled promptly at the asking price. This cuts out the timing cost, which according to DLJ is 85% of the total trading cost.

Put another way, individual investors enjoy a 7-to-1 advantage in trading costs by managing their own account rather than pooling their money in a mutual fund.
Ted Murphy ( ted@pdgm.com ) operates the MarketPlayer Web site. Previously he was a partner at Equinox Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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