Transaction cost analysis (TCA) lacks transparency, offers an incomplete picture of trading efficacy and makes it hard to genuinely compare performance. This is the damning assessment of the asset management sector from consultancy Bfinance.
In research shared exclusively with Institutional Asset Manager, Bfinance reports that despite efforts from regulators and industry associations to encourage asset managers to reveal their costs – notably through MiFID II, the Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation, the UK Cost Transparency Initiative and RG97 in Australia – “disclosure does not always equal transparency, nor does it necessarily drive good practice; indeed, it can do the opposite”.
Bfinance’s report Transaction cost analysis: Has transparency really improved? argues that regulations designed to improve TCA is flawed and suffers from several shortcomings.
“[MiFID and PRIIPS] instruct on the provision of a single final number combining explicit cost, implicit cost and dilution adjustment. This final number is very difficult to analyse or interpret,” says Duncan Higgs, Managing Director, Portfolio Solutions at Bfinance and co-author of the report.
He adds investors should look beyond a specific measure of price and consider other benchmarks such as the Volume-Weighted Average Price, open-close and high-low “for a more comprehensive understanding of market dynamics and execution strategies”.
The Bfinance report also highlights the lack of harmony between TCA methodologies across different jurisdictions. For example, the EU Cost methodology establishes that the aggregated transaction cost figure cannot be lower than the explicit cost figure, whereas the UK cost methodology merely requires that the aggregated figure cannot be negative.
Higgs further criticises TCA for failing to make relevant inefficiencies visible.
“Aggregated reporting does not show up specific nuances, such as whether a broker is particularly poor in some markets versus others,” he says.
Finally, according to Bfinance, current TCA lacks context on overall outcomes meaning investors cannot be sure whether lower transactions costs resulted in better overall execution.
“For example, a manager that instructs the sale of stock whose price then rises when trading opens may enjoy an implicit transaction cost of zero while the manager who has instructed to buy that stock may suffer an implicit transaction cost, but the latter decision would evidently be preferred from the point of view of overall investment returns,” Higgs explains.
And while the consultancy is slightly more forgiving of the institutional initiatives which “do go further [than PRIIPS and MiFID II] in terms of enabling a split between the different sub-components within explicit cost, implicit cost and anti-dilution offset “they still do not produce the context required to interpret the numbers”.
No wonder then that large swathes of institutional investors around the globe are dissatisfied with the current state of TCA market.
A July survey of 200 senior investment professionals found just 23 per cent are satisfied with ‘comparability’ while the figures for the ‘market impact’ component of transaction costs were even lower, reflecting what Higgs describes as “the persistent low visibility of this cost element”. Further, a very large minority of respondents indicated that they ‘don’t know’ whether these costs are transparent, illustrating an ongoing lack of awareness.
Unsurprisingly all this leads Bfinance to conclude that “transaction cost analysis models still need work” and that investors “should not expect asset managers’ disclosures—driven by regulation or otherwise—to produce the transparency that is required for good practice”.
Higgs concludes “Investors must stay alert to the potential risk of unintended consequences. Once a cost becomes visible and has to be disclosed, there emerges an incentive to minimise that cost or at least the visible aspect of that cost, especially if the manager believes that the disclosed number may affect clients’ decisions. That incentive may not necessarily be aligned with the ultimate goal: maximising returns.”