Investment Product Costs and Performance
Performance of an investment product can be significantly influenced by various costs. For instance, two investment strategies with the same approach can have different costs based on the manager’s implementation approach. The difference can be so significant that one strategy could cost twice as much to manage as another.
Assets Under Management (AUM)
Assets Under Management (AUM) is a key factor that affects the position size in an investment strategy. For example, a large hedge fund with a high AUM will have different position sizes and liquidity compared to a smaller mutual fund. The position size and the liquidity of the securities in the portfolio will determine the level of turnover that can be maintained at an acceptable cost level.
Explicit and Implicit Costs
Investment funds with smaller AUM may have higher explicit costs, such as broker commissions. However, these funds may have lower implicit costs, such as delay and market impact, compared to larger AUM funds. Therefore, smaller funds may be able to sustain higher turnover and still deliver superior performance.
It is essential for a manager to carefully consider both explicit and implicit costs in their implementation approach. A balance must be struck between the potential benefits of turnover and the costs of turnover. When considering a portfolio rebalancing or restructuring, the benefits of the post-trade risk/return position must justify the costs of achieving it.
Explicit costs such as broker commissions, financial transaction taxes, custody/safekeeping fees, and transaction processing are covered in other parts of the CFA Program curriculum.
Market Impact Costs
Market impact costs are a significant implicit cost that can greatly reduce a manager’s alpha. Essentially, market impact is the price movement that results from a manager’s purchase or sale of a security. The extent of market impact is determined by the liquidity and trade size of the security. A manager’s investment approach and style also play a crucial role in determining the exposure to market impact costs. For instance, a manager who requires immediate execution or has a higher portfolio turnover is likely to incur higher market impact costs. Conversely, a manager who patiently trades into a position or believes in long-term investment horizons can mitigate market impact costs by slowly building up positions as liquidity becomes available.
Factors Influencing Market Impact Costs
Market impact costs are also influenced by the information contained in trades. A trade is said to contain information when the manager’s decision to buy or sell the security signals a change to the market. For example, if a manager with sizable assets under management, such as Warren Buffet, starts buying a stock, it signals to other market participants that there is likely to be upward pressure on the stock price. Some market participants may try to front-run the manager, buying up known supply to sell it to the manager at a higher price. Conversely, if the manager starts selling his position following a company event, it signals to the market that the manager’s view on the stock has changed, likely leading to downward pressure on the price.
Impact of Assets Under Management, Portfolio Turnover, and Liquidity
Assets under management, portfolio turnover, and the liquidity of the underlying assets all affect the potential market impact costs. The relationship between the size of a security, as measured by its capitalization, and a manager’s ability to trade in this security, as measured by its average daily trading volume, is also important. The distribution of market cap is skewed, with the average capitalization declining quickly. Smaller-capitalization companies have lower daily trading volume but trade a greater percentage of their capitalization. However, the lower absolute level of average trading volume of smaller securities can be a significant hurdle for a manager running a strategy with significant assets under management and significant positive active weights on smaller companies.
Impact of Fund Size on Operational Efficiency
The size of a fund affects operational efficiency, particularly in terms of trading volume and position size. Larger funds, such as the Vanguard 500 Index Fund, may struggle with position size constraints, as substantial stakes in securities require substantial average daily trading volumes—volumes that not all securities can sustain.
Strategic Responses to Size Constraints
Large funds can manage size constraints by setting position limits relative to market-cap weights and trading volumes. A dual approach of capping allocations at either a fixed percentage above market-cap weight or a multiple of the security’s index weight ensures that large positions are manageable. Additionally, funds may limit positions to a set number of days of average trading volume to avoid liquidity issues.
Adopting a flexible rebalancing strategy that allows for gradual portfolio adjustments can mitigate the impact of size constraints on investment performance. By extending the rebalancing timeline, large funds can navigate operational challenges more effectively.
Challenges for Small-Cap Funds
The challenges are even greater for small-cap funds. The weighted average capitalization of the Russell 2000 Index is only $2.2 billion, and nearly 60% of the companies in the index have a market capitalization below $1 billion. The average market cap of companies over this $1 billion market-cap threshold is only $1.2 billion. The average daily volume of these “larger” companies is approximately 2% of their market capitalization—less than $25 million.
A small-cap manager with the same limits on position size relative to trading volume as the manager above would have an average position size of no more than $2.5 million, based on average daily trading volume. A strategy rooted in a smaller number of securities may find it difficult to run a $100 million fund and may have to concentrate its allocation among the 25% largest securities in the index or accept a lower turnover.
Although a strategy with a larger number of securities would be able to support a substantially higher level of AUM, it may still be constrained to concentrate its exposure among the larger and more liquid securities. Small-cap funds with capacities of $1 billion or greater may very well need to hold 400 securities or more.
Consistency of Strategy
The strategy of the manager must be consistent with the feasibility of implementing it. A high-turnover strategy with a significant allocation to smaller securities will at some point reach a level of AUM at which the strategy becomes difficult to implement successfully. The level of idiosyncratic risk inherent in the strategy will also play a role in the suitable level of AUM. A manager targeting low levels of idiosyncratic risk in his portfolio is likely to have more securities and smaller position sizes and could, therefore, conceivably support a higher level of AUM.
Estimating the Cost of Slippage
The slippage refers to the difference between the expected price of a trade and the price at which the trade is executed. It is a crucial concept for investors and traders to understand as it can significantly impact the profitability of their trades.
Measuring Slippage
Slippage is quantified as the discrepancy between the execution price and the midpoint of the bid and ask quotes when the trade was initially placed. This measurement encapsulates both the effects of volatility/trend costs and market impact. For instance, volatility/trend costs are the expenses associated with purchasing in a rising market and selling in a declining one. This metric provides an approximation of the cost to carry out a transaction when the order is executed in a single trade.
Trade Size, Execution Strategy, and Their Impact
The size of a trade and the strategy used for its execution can significantly influence slippage. For example, when a large trade is executed in increments over multiple days, the estimate of market impact costs for later trades does not account for the impact of earlier trades on subsequent execution prices. Large institutional investors often break a trade into many smaller trades or trade in “unlit” venues, such as dark pools and crossing networks, to mask the potential size of their trade.
Liquidity, Market Conditions, and Their Impact
Research has shown that small-cap stocks consistently have higher effective trading costs than large-cap stocks. The larger a trade size relative to a stock’s average daily volume, the more likely it is that the trade will affect prices. Therefore, a fund focusing on large-cap stocks can support a higher level of Assets Under Management (AUM) than a similar-strategy fund focusing on small-cap stocks.
Managing Slippage Cost
Slippage cost can be managed with a strategic approach to implementation. For some strategies, the true cost of slippage may be the opportunity cost of not being able to implement the strategy as assets grow. If the manager’s level of AUM grows and this approach is modified, it may have unanticipated consequences for expected risks and returns to investors.
In conclusion, slippage costs are usually more significant than commission costs and are greater for smaller-cap securities than for large-cap securities. Slippage costs can vary substantially over time, especially when market volatility is higher.
Practice Questions
Question 1: An investment manager is considering the implementation of a new investment strategy. The manager is aware that the costs associated with the strategy can significantly influence its performance. The manager is also aware that the size of the assets under management (AUM) can affect the position size in the strategy and, consequently, the level of turnover that can be maintained at an acceptable cost level. Which of the following statements is most likely to be correct?
- Smaller AUM funds will have higher explicit costs and higher implicit costs, making them less likely to deliver superior performance.
- Larger AUM funds will have lower explicit costs and higher implicit costs, making them more likely to deliver superior performance.
- Smaller AUM funds may have higher explicit costs but lower implicit costs, potentially allowing them to sustain higher turnover and still deliver superior performance.
Answer: Choice A is correct.
Smaller AUM funds will have higher explicit costs and higher implicit costs, making them less likely to deliver superior performance. Explicit costs are the direct costs associated with executing a trade, such as commissions, taxes, and other fees. Implicit costs are the indirect costs associated with trading, such as the impact on the price of the security due to the size of the trade. Smaller funds, due to their lower AUM, will have less bargaining power with brokers and other service providers, leading to higher explicit costs. Additionally, smaller funds may also face higher implicit costs due to the lack of liquidity in the market for the securities they trade. This lack of liquidity can lead to higher price impact costs, which are a type of implicit cost. These higher costs can significantly impact the performance of smaller funds, making them less likely to deliver superior performance compared to larger funds.
Choice B is incorrect. Larger AUM funds will not necessarily have lower explicit costs and higher implicit costs. While larger funds may have more bargaining power with service providers, leading to lower explicit costs, they may also face higher implicit costs due to the larger size of their trades. However, these higher implicit costs may be offset by the lower explicit costs, making it unclear whether larger funds are more likely to deliver superior performance.
Choice C is incorrect. Smaller AUM funds may not necessarily have higher explicit costs but lower implicit costs. While smaller funds may face higher explicit costs due to their lower bargaining power, they may also face higher implicit costs due to the lack of liquidity in the market for the securities they trade. Therefore, it is not clear whether smaller funds can sustain higher turnover and still deliver superior performance.
Question 2: The strategy of the manager must be consistent with the feasibility of implementing it. A high-turnover strategy with a significant allocation to smaller securities will at some point reach a level of AUM at which the strategy becomes difficult to implement successfully. The level of idiosyncratic risk inherent in the strategy will also play a role in the suitable level of AUM. Which of the following is a potential solution for a manager facing these challenges?
- The manager should target low levels of idiosyncratic risk in his portfolio.
- The manager should have more securities and smaller position sizes.
- Both A and B are potential solutions for a manager facing these challenges.
Answer: Choice C is correct.
Both A and B are potential solutions for a manager facing the challenges of a high-turnover strategy with a significant allocation to smaller securities and a high level of idiosyncratic risk. Targeting low levels of idiosyncratic risk in the portfolio can help to mitigate the risk of individual securities having a significant impact on the overall portfolio performance. This can be achieved by diversifying the portfolio across a larger number of securities, thereby reducing the weight of each individual security in the portfolio. On the other hand, having more securities and smaller position sizes can also help to mitigate the impact of individual securities on the portfolio and make the strategy more manageable as the level of assets under management (AUM) increases. This can also help to reduce the transaction costs associated with a high-turnover strategy, as smaller trades are generally less costly to execute. Therefore, both of these strategies can help a manager to continue to implement a high-turnover strategy successfully as the level of AUM increases.
Choice A is incorrect. While targeting low levels of idiosyncratic risk can help to mitigate the impact of individual securities on the portfolio, it is not a complete solution to the challenges faced by a manager implementing a high-turnover strategy with a significant allocation to smaller securities.
Choice B is incorrect. While having more securities and smaller position sizes can help to mitigate the impact of individual securities on the portfolio and make the strategy more manageable, it is not a complete solution to the challenges faced by a manager implementing a high-turnover strategy with a significant allocation to smaller securities.
Glossary
- Assets Under Management (AUM): The total market value of the investments that a person or entity manages on behalf of clients.
- Explicit Costs: The direct costs associated with an investment, such as broker commissions, financial transaction taxes, custody/safekeeping fees, and transaction processing.
- Implicit Costs: The indirect costs associated with an investment, such as delay and market impact.
- Total Assets Under Management: The total value of the assets that a manager has under his control.
- Maximum Position Size as a Percentage of Total Assets: The maximum percentage of the total assets that a manager is allowed to invest in a single security.
- Average Daily Trading Volume of Security: The average amount of a security that is traded each day.
- Maximum Position Size as a Percentage of Average Daily Trading Volume: The maximum percentage of the average daily trading volume of a security that a manager is allowed to own.
- Slippage: The difference between the expected price of a trade and the price at which the trade is executed.
- Unlit Venues: Trading platforms that allow buyers and sellers to trade anonymously with one another. Examples include dark pools and crossing networks.
Portfolio Management Pathway Volume 1: Learning Module 3: Active Equity Investing: Portfolio Construction;
LOS 3(i): Discuss how assets under management, position size, market liquidity, and portfolio turnover affect equity portfolio construction decisions