Trading

S tudies periodically jolt investors with new 10 $ r evidence that they rarely ”beat the market.” Somehow, dart board techniques confound the typical investment manager most of the time. In too many years, capitalization-weighted portfolios that are managed underperform the capitalization-weighted index by about a percentage point. The cost of the trading system partially explains this intuitively jarring underperformance by skilled professionals. While there may be differences of opinion about how to measure trading costs, investment managers are realizing that trading costs are related to investment returns. We can measure trading costs in several ways. One way is to calculate the difference between the price of the stock immediately before entering the order and the net cost or proceeds. Another is to figure the difference between the net costs or proceeds and the price of the security shortly after trading it. To do either rather than both is like trying to measure the height of a house above ground by looking at only one side of it. If the house sits on a slope, we will get different answers depending on which side we approach. In the case of buying a stock, if favorable information reaches the market before execution, the transaction cost may appear high when in reality the price adjustment had nothing to do with trading, but with security valuation instead. A similar analysis applies to measuring after the trade. A truer picture of the cost may be to measure both ways and take either the average or smaller of the two. This will approximate 1% per side for most institutions. Multiplied by portfolio turnover and added to management fees, the total shortfall is approximately 1% One percent seems small in comparison to the r typical equity volatility of 22% annually, but 1% less return each year leads to 20% less accumulated wealth in 25 years and 36% less in 50 years. Very few investment strategies can overcome this sort of penalty. One percent per year of managed institutionalized assets is billions of dollars.