A Primer on Trading Costs
At Clarity Capital Advisors, we strive to keep our client’s costs as low as possible without sacrificing quality in any aspect of service. One source of expense that we carefully monitor is trading costs. By “trading costs” we mean both the costs incurred when we place trades and the trading costs incurred inside the funds we utilize for our clients. This article will focus on the latter. Unfortunately, trading costs are not directly available for mutual funds or exchange-traded funds. Instead, they show up as a decrement to the return received by the shareholders.
Trading costs are composed of both explicit costs (e.g., commissions, custody fees, and exchange fees) and implicit costs (bid-ask spread, market impact, and opportunity cost). Regarding explicit costs, the fund company we utilize for equities (Dimensional Fund Advisors) regularly reviews commissions to ensure the rate paid is the lowest possible while maintaining positive results with respect to implicit trading costs. In all four categories of US Large Cap, US Small Cap, Non-US Developed, and Emerging Markets, Dimensional had substantially lower historical commission rates in 2016 than its peer group, according to data produced by the Investment Technology Group. To determine the impact of the lower commission rates on fund returns, we need to consider the turnover rates. For Dimensional’s US Core Equity 1 Portfolio (DFEOX), the annual turnover is 4% compared to 55% for its category average, according to Morningstar. The turnover of Dimensional’s International Core Equity Portfolio (DFIEX) is 2% compared to 57% for its category average. Lastly, Dimensional’s Emerging Markets Core Equity Portfolio (DFCEX) comes in at 3% compared to 65% for its category average. Thus, for all three categories, Dimensional’s explicit trading costs are more than an order of magnitude lower than its peer group. While one may argue that the peer group consists of actively managed funds that supposedly add value through trading (spoiler alert: they don’t), it is important to note that index funds, especially ones based on the Russell indices, incur the costs associated with index reconstitution, when all the funds are placing the same trades on the same days.
Since Dimensional’s funds are neither traditional index funds nor active funds, they can take a flexible and patient approach to trading. For example, if a fund has $1 million to spend on security purchases, it is not restricted to just a few names. At any given time, there may be dozens of companies that meet the parameters of a fund, and the fund manager is indifferent among them. This flexibility allows Dimensional’s traders to obtain good prices on their orders, and even in this age of computer-dominated high-frequency trading, it is still true that the motivated party pays for the trade by jumping the spread. In all its transactions, Dimensional considers the trade-off between trading costs and the daily expected returns of targeted securities. This, we believe, is the best approach for adding value for its shareholders/our clients. To learn more about how Clarity can build a portfolio of Dimensional funds for you, please call us at 800-345-4635 or e-mail us at email@example.com.