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Investment Costs, Trading Costs, The Bid/Ask Spread

     Consumer Reports reported on an interesting survey in January 2010.1 They asked over a thousand Americans to score 21 gripes on a 1-to-10 scale, 1 meaning an experience "does not annoy you at all" and 10 meaning it "annoys you tremendously." “Hidden fees” was the most annoying gripe in the survey with an average score of 8.9. So we know that people are extremely annoyed by hidden fees and in investing there are many hidden (in additional to visible) costs. But the reality is most investors struggle to quantify all the investment costs they incur.

     A 2017 survey conducted by Harris Poll on behalf of Personal Capital found that 61% of those polled disagreed with the statement “I know the amount of fees I pay on all of my investment accounts.” 32% of respondents agreed that higher fees for investment accounts generally result in higher returns, which was an improper perception the data did not support.2

     Most investment costs can be determined or estimated fairly easily, but a large percentage of investors don't have a clear understanding of their costs and they often don't grasp the magnitude of how those costs erode their portfolios over time. In fact, many investors have no idea how much their advisors are deducting from their portfolios, or how much in fees gets subtracted from their returns in many products. When you consider the difference in ending portfolio values from one, or two, or even more percent costs over many years, it can be extremely depressing, especially when you translate that into the number of extra years you may have to work in order to retire comfortably. According to one study, the average American pays more than $369,000 in bank and investment account fees over the course of their lifetime.3

     Charles Schwab uses an example of in investor with $1 million invested in a portfolio that earns 6% over the following 40 years. With investment costs of 2% per year, the portfolio would grow to $4.8 million, but if costs were instead 1% per year, it would grow to $7 million (the extra 1% in costs result in a $2.2 million smaller portfolio).4

     Commissions and fund annual expenses tend to be transparent and they have been studied and analyzed by academics and the press. But other investment costs tend to be more opaque, or more difficult to identify and calculate. There are many costs that investors may incur depending on their investment vehicles, specific securities, and various advisory services. Both individual do-it-yourself investors, as well as investors using one or more services face many of the following costs.

     For an investor that has determined their target asset allocation, the next step is to invest in specific funds and/or securities. Some investments like government bonds can be purchased with no direct costs, while others like hedge funds may have multiple layers of costs. Passive investors generally purchase diversified funds, while active investors attempt to improve on index or asset class returns by holding specific securities or subsectors and/or timing those investments.

     Investors in retirement accounts like IRAs and 401(k)s generally face 1) management and administrative costs as well as 2) fund expenses. Investors using investment advisers or financial planners generally face either asset based fees, or hourly fees in addition to the costs related to the actual products or securities. Investors using full service brokers potentially face additional broker commissions and other fees like wrap fees. High net worth and institutional investors traditionally have had access to lower cost products and services, but may pay additional consulting fees. Those that invest in venture capital, private equity, and hedge funds may face additional performance fees and/or additional layers of fees, for instance from funds of funds.

     A useful exercise for investors is to start with theoretical expected returns (usually based on historical returns and current interest rates) and then subtract expected costs. The term "Implementation Shortfall" was coined by Harvard professor Andre Perold using a simple definition of the difference between theoretical paper portfolios and actual real-money portfolios. Implementation shortfall is particularly relevant for investors and funds with enough assets to affect prices significantly when they make trades, but for most individual investors, the implementation shortfall consists of fees, commissions, and spreads (plus tax affects in non-retirement accounts).

     Half a century ago, most investors in equity mutual funds purchased funds that had front-end-loads that were sold through brokers or advisors, which received commissions on the sales. That practice shifted in recent decades to the use of funds that charge an annual fee, above the funds’ annual management fee. Directly sold funds with no sales charges now represent a much larger percentage of mutual fund purchases.

     Brad Barber, Terrance Odean, and Lu Zheng determined that the proportion of diversified U.S. equity mutual fund assets invested in front-end-load funds dropped from 91% in 1962 to 35% in 1999.5 In contrast, asset-weighted operating expenses for the funds increased by more than 60%, from 54 basis points to 90 basis points, despite increasing assets under management. Marketing and advertising costs are often embedded in funds’ operating expenses and the authors argued investors buy funds that attract their attention through performance, marketing, or advertising.

     Todd Houge and Jay Wellman argued in 2006 that the industry had become more adept at segmenting customers by their level of investment sophistication and load mutual fund companies used that to charge higher expenses to their target customers (less knowledgeable investors).6 Over time the industry has regarded 12b-1 fees as a substitute for sales loads, shifting a portion of the up-front charges to the annual expense ratio where they are less likely to be noticed by investors. They also found an increase in abuse of sales distribution or 12b-1 fees by funds that were closed to new investors, almost all of which were load funds. The biggest players in 12b-1 fees as off 2009 were Blackrock ($1.1 billion), followed by Franklin Resources, Legg Mason, and AllianceBernstein.7

     Daniel Bergstresser, Peter Tufano, and John Chalmers studied broker-sold and direct-sold funds from 1996 to 2004, and did not find evidence that brokers deliver substantial tangible benefits (despite the huge fees they were paid).8 In 2002, they estimated mutual fund investors paid $15 billion in distribution channel fees: $3.6 billion in front-end loads, $2.8 billion in back-end loads, and $8.8 billion in 12b-1 fees (compared to $23.8 billion spent on investment management fees and all other operational expenses).

     Financial Advisory fees charged by investment advisors historically hover around 1%, but tend to vary based on the size of the account. Most firms that charge fees based on a percentage of assets under management use a sliding scale with larger accounts paying less. Other investment advisors charge hourly fees, or fixed fees per year.

     A 2014 study by PriceMetrix, Inc. calculated the industry average at 1.02%. According to AdvisoryIQ's 2017 Report, the average fees were the following.9

     Michael Kitces elaborated on the all-in advisory fees in pointing out that in addition to the advisory fee, platforms separately charge a platform fee. Kitces estimated the median all-in cost to the investor with less than $250,000 portfolios was actually 1.85%, dropping to 1.75% for portfolios up to $500,000, and 1.65% up to $1,000,000.10

     Online advisory firm Personal Capital reported data on advisory firm costs in 2015. They examined anonymous data from more than 150,000 of their users to investigate the true client costs from both advisory and fund-related fees across 11 brokerage firms. They claimed that Merrill Lynch had the highest average expense ratios on mutual funds and ETFs (0.68%) and the third highest average advisory fee (1.3%) for an average total fee to the client of 1.98%. The data showed TD Ameritrade had the highest average advisory fees at 1.53%, but among the lowest asset management fees on its mutual funds and ETFs (0.21%).11

     Personal Capital followed up in 2017 and found the highest estimated possible fee was through the Ameriprise Managed Accounts & Financial Planning program, where advisory plus fund management fees could exceed 3% per year. The lowest was through Vanguard Personal Advisor Services. In the study, Ameriprise’s program was followed by UBS’ portfolio management program (2.94%) as having the highest cost financial advice service. Next were Morgan Stanley’s Select UMA (up to 2.92%), Wells Fargo’s private investment management (up to 2.43%), Merrill Lynch (up to 2.33%), JPMorgan (up to 1.86%) and Edward Jones (up to 1.80%). Rounding out the pack were Personal Capital investment services/wealth management (up to 0.97%), Charles Schwab Intelligent Advisory (0.44%) and Vanguard (about 0.38%).12

     Ameriprise disputed the study, questioning its methodology, and told FinancialAdvisorIQ its clients’ average advisory fee is around 1% “and varies based on the products and services each individual client wants and needs.”13

     The Commonfund Institute surveyed over 700 institutions and they estimated their all-in costs were 0.5%, but only 18% included incentive and performance fees paid to asset managers, despite the fact that 85% of them reported having allocations to alternative investment strategies, which usually have extra incentive and performance costs. They determined with more detailed estimates from some of the clients that costs appear to be no less than 1% and closer to 1.75% for more complex portfolios.14

     Ken French published one of the broadest studies of investment costs in his August 2008 paper "The Cost of Active Investing" published in the Journal of Finance. Using multiple sources of data, French conservatively estimated equity costs resulting from active management. In the process he also provided some fascinating information about the investment industry and its evolution over the prior few decades. Specifically he looked at costs for both individuals and institutions, by determining mutual fund and hedge fund management fees, and as well as the costs of the trading. The cost differential between active and passive was 0.67% and that number was surprisingly stable from 1980 to 2006. He did not include tax costs, nor typical investment advisory fees, and some other costs (as well as costs for time spent) that investors often incur. The overall costs by his calculations had been relatively steady, but drops in some categories (mostly from decreasing use of load fees and investors switching to passive investing) have been offset to some extend by increases in hedge fund costs. French’s estimate was lower than some other recent estimates summarized by Burton Malkiel and Jack Bogle (which ranged from 0.71% to 1.13%).15

     The turnover information in French's study was particularly striking. Annual turnover of U.S. stocks multiplied from 20% in 1975 to 215% in 2007 (284% with ETFs). Turnover on the NYSE peaked in 2008 and then trended lower for several years. Annual turnover according to more recent data averaged about 150% from 2013 through 2015.16 The Wall Street Journal reported in October of 2017 that short-term trading volumes were falling perhaps due to low volatility, a lack of market-moving news, and the rising popularity of passive investment funds, which has kept many investors on the sidelines.17

     Despite that increase in turnover, the total amount investors payed to trade declined from $50 billion in 2000 to $32 billion in 2006. French also supplied estimates of the percentage of investors investing passively. Open-End mutual funds went from 0.8% passive in 1986 to 12.6% in 2006. He estimated that 26% of Public plans were passive in 1986 rising to 52% by 1997. French noted that the benefit of active investing is that active investors almost certainly improve the accuracy of financial prices, which improves society’s allocation of resources. To the blunt question of why do active investors continue to play a negative sum game, French suggested 1) lack of education about the advantages of passive investing 2) and overconfidence.

     Burton Malkiel suggests that the number of active managers still exceeds what is required to make our stock markets reasonably efficient given that no clear arbitrage opportunities remain unexploited. He argues that throughout the world, highly trained independent experts are estimating securities values each day and outperforming the consensus of those professionals has been unlikely for decades.18

     Jack Bogle also commented on the financial industry in his 2008 book Enough and in a Winter 2008 Journal of Portfolio Management article titled "A question so important that it should be hard to think about anything else." Bogle estimated society’s cost of investing in 2007 was $528 billion. He pointed out in the book "No one knows the exact number. All that can be said for certain is that, one way or another, these billions are paid by investors themselves."19

     In 2014 Bogle estimated that active funds for retirement plan investors cost 2.27% all-in (1.12% expense ratio, 0.5% transactions costs, 0.15% cash drag, and 0.5% sales charges/fees) versus 0.06% for index funds. Translating that into performance, Bogle projected $10,000 invested in actively managed funds would grow in to $48,000 in 40 years, while $10,000 invested in index funds would grow to $131,000.20

     Investment costs are analogous to “vigorish” (also known as the vig, juice, or the take), the amount charged by a bookmaker, or bookie, for his services (some also use it as a term for the interest charged by a loan shark). The term is Yiddish slang originating from the Russian word for winnings.21 In fact, Jack Bogle often used the term croupier (meaning casino dealer) for the investment industries "take."

     For some perspective (as I noted in chapter five), I compared French’s estimate for the amount spent annually on active management in the U.S. versus gaming revenue estimates. From 2002 to 2006 both rose steadily with active management costs slightly higher than gaming revenues each year. French estimated U.S. investors spent over $100 billion (more than $330 dollars in resources for every man, woman, and child in the United States) trying to beat the stock market in 2006, while the American Gaming Association estimated all U.S. gaming revenue was $91 billion. Estimates tend to show the U.S. with the highest gambling losses, followed by China, Japan, and Italy.22 U.S. gambling losses in 2017 were estimated at more $150 billion, about half coming of that from lotteries, followed by commercial, then tribal casinos.23

     Morningstar and others frequently analyze how mutual fund expenses impact, or even predict performance.24 For instance in 2010, Russel Kinnel summarized "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds."25 The best predictor of fund performance is expense ratio and in investment management the saying “you get what you pay for” is usually wrong. The correct phrase in investing is, “you keep what you don't pay for.”

     There is also some recent research suggesting that mutual fund managers tend to be compensated less for performance and more for their marketability and increases in assets under management.26 One problem with that is assets under management at firms tend to rise in general because the asset class rises, as opposed to the manager outperforming the market.

     A February 2015 report from the Obama administration was released to support legislation on a fiduciary standard (which I’ll discuss more in chapter 30).27 The report estimated that savers in accounts with advisors that have conflicts of interest earn 1% lower returns than accounts with un-conflicted advisors. They estimated the aggregate annual cost of conflicted advice was about $17 billion each year on the estimated $1.7 trillion of IRA assets that were invested in products that generally provide payments that generate conflicts of interest. They listed the following types of payments that generate conflicts of interest.

     The study also referred to prior related research including a study that compared the performance of accounts in an Oregon workplace retirement plan where plan participants had lost access to conflicted advisers.28 They found that participants who would have otherwise used conflicted advice were disproportionately more likely to rely on the plan’s default investment options in their absence, and those default investment options performed better than the portfolios of those receiving conflicted advice. In the authors’ words, “brokers significantly increased annual fees, significantly decreased annual after-fee returns, and slightly increased risk-taking relative to the counterfactual portfolio” (that is, the default investment option). The estimated magnitude of underperformance in the study was 298 basis points relative to the plan’s default investment option.

     The white house paper authors also estimated underperformance between portfolios selected with or without conflicted advice. After controlling for various measures of investor traits, they found that the conflicted portfolios underperformed by approximately 1.25%. Similarly, researchers examining retail investment advice in Canada and Germany (where the legal regimes differ but advisers also derive substantial compensation from conflicted payments) found that advised accounts underperformed by more than 1.5%.29

401 (k) costs
Data on costs for 401(k) investors is provided by multiple sources, including BrightScope and the Investment Company Institute. Penelope Wang, summarized in Consumer Reports at the end of 2018 "Generally, if your 401(k) plan's total costs are 1.5 percent or more, you're paying more than you should"30 but I would suggest plan participants investigate anything over 1%. In 2012, the average total plan cost was 0.91 percent of assets, down from 1.00 percent in 2009. BrightScope’s total plan cost includes administrative, advice, and other fees from Form 5500 filings, as well as asset-based investment management fees. Mutual fund expenses in 401(k) plans tend to be lower in larger plans and their costs have trended down over time. For example, the average asset-weighted expense ratio for domestic equity mutual funds was 0.95 percent for plans with less than $1 million in plan assets, compared with 0.48 percent for plans with more than $1 billion in plan assets.31

Alternative Investments Costs
Preqin provides data on private equity, venture capital, and private real estate funds. They reported that private fund average management fees traditionally hover around 2%, while private equity funds of funds (which impose multiple layers of fees) and private equity secondaries funds, had a mean cost around 0.9%. Venture capital funds also tend to have average management fees around 2% (although more than a quarter charge over 2.5%). Large real estate fund ($1 billion or more) managers charge about 1.1%, while small real estate funds (less than $500mn) tend to charge around 1.5%.32

Hedge Fund Costs
Kenneth French estimated the average annual hedge fund fee from 1996 to 2007 was 4.26% of assets, and the average for clients who buy through funds of hedge funds was 6.52% per year (because they pay two layers of fees). In 2007, 45% of all hedge fund assets were invested in funds of funds. I’ll discuss Hedge Funds in more depth in chapter 17, but specifically regarding costs, the commonly used term “2 and 20” refers to charging 2% of assets annually, plus 20% of profits and that fee structure dates back to 1949, when Alfred Winslow Jones founded AW Jones & Co, considered by many to be the first hedge fund. But multiple studies estimate hedge fund fees have been dropping steadily in recent years, although the estimates vary.33

     Institutional Investor reported in 2010 that hedge funds of funds were rapidly (and deservedly) losing business. The entire investment industry was still recovering from the global financial crisis at that time, so it may have been more than just the business model impacting the fund flows. "According to HFR, over a 20-year period, the funds underperformed the S&P 500's before survivorship bias (the index does not include funds that went out of business or simply chose not to report their performance if they do lousy). In addition to the typical charges by the underlying funds, the fund of funds charges, on average, a 1.27 management fee and 6.94 percent performance fee, according to Ken Heinz, President at Hedge Fund Research."34

     According to a 2016 Fortune article, the average annual management fee charged by Hedge funds had fallen to 1.39% of the value of a client’s assets, from 1.44% in 2015, and 1.68% about a decade ago, according to the data from industry monitor Eurekahedge. Funds also cut their performance fees, from an average of 18.77% across the global industry in 2007 to 16.69%.35 Eurekahedge reported hedge fund fees have dropped to 1.2% in the first half of 2019 (plus 14.5% performance fees)36 while another recent source reported hedge fund management fees at 1.3%.37

     According to Preqin, the mean fee for hedge funds launched each year has been decreasing for about a decade, driving the average management fee down to 1.56%. 73% of funds launched in 2016 charged a 20% performance fee, but that was down from 87% in 2007.38

     JP Morgan also reported in 2019 that 54% of investors they surveyed were negotiating or looking to negotiate lower fees for hedge funds.39 But not all Hedge Funds have been cutting fees, for instance D.E. Shaw Group planned to raise the fees it charges for its $14 billion flagship D.E. Shaw Composite fund to a 3 percent management fee and 30 percent performance fee, according to The fund had previously charged fees of 3-and-30 from 2003 to 2011, but it then lowered those fees to 2.5 percent and 25 percent.40

Trading Costs
Transactions Costs or Trading Costs (TC) are terms commonly used in the investment business to identify the cost of buying and selling securities (usually common stocks). There is some debate and/or confusion regarding defining trading costs since some participants use different metrics like Value Weighted Average Price (VWAP) as a definition, but most define trading costs (in the Implementation Shortfall methodology) as the difference between an investor's average trade price versus either 1) the last price traded or 2) mid-point of the bid-ask spread when the investor began trading.

     For small trades in liquid markets, trading costs can be miniscule, but they can be substantial for large trades especially in less liquid markets. For instance, an investor buying 100 shares of a common stock or ETF on the open or close may have virtually no cost, but a large firm trying to sell millions of shares of a smaller capitalization stock that just announced weaker than expected earnings may have costs of several percentage points. While many firms have a one-day trading horizon, larger firms often trade illiquid orders over several days, and some trade weeks, or months on the same order.

     While trading costs have not been a required disclosure for mutual funds, they have become more transparent in the last few decades. Mutual funds are required to report three years of commission costs, which are one component of trading costs. Many firms calculate trading costs internally or via outside vendors and in the last few decades, academics and others have been estimating the costs fairly effectively using publicly available information.

     There are many firms that offer Transactions Costs Analysis (TCA) to large investors, but the commonly recognized pioneer in the field of transactions costs and implementation shortfall analysis was a firm named Plexus Group (founded in the 1980s).41 Plexus was sold to JP Morgan Chase in 2002 and then sold to ITG in 2006. I joined Plexus Group in 1998 and worked at the twice merged company until the end of 2009.

     My former boss at Plexus Wayne Wagner used an analogy of an iceberg in explaining transactions costs. The commissions and impact are visible (above the surface), but delay and opportunity costs are harder to calculate (below the surface) and often exceeded the visible costs. The image below highlights the various costs, which have dropped in recent decades. Yet the analogy remains relevant for individual investors, which may incorrectly assume zero commission trading means they have no trading costs. Spreads, and other fees (as well as taxes for some) are likely to be significant even with no commission trading.

     ITG (prior to merging with Virtu in 2019) posted statistics from their trading cost universe quarterly. For instance, their Global Cost Review for the third quarter of 2018 included data back to the fourth quarter of 2009. Their total costs were commissions plus Implementation Shortfall, which is the difference between the price of the stock when the order was placed and the price when the trade was made. According to their data for Q32018, United States trading costs averaged 0.31%, of which .03% was commissions. Micro caps cost 0.63%, while large cap costs averaged 0.28%. Japan and UK costs averaged 0.45%, versus 0.41% for Europe Ex-UK, and Asia Ex-Japan with 0.49%. Canada trading costs averaged 0.34%, while Emerging Markets averaged 0.65%. Opportunity costs on unfilled orders were usually not included in trading cost estimates.42

     A useful recent paper on trading costs (titled "Trading Costs") summarizes several of the recognized sources and suggests that trading costs are lower than prior estimates, but the focus of the data in the study is a single manager (two of the authors are with AQR) and the orders were generally traded "passively" which will tend to have lower impact than more motivated trading.43

     There is a common misconception that using a passive trading strategy (using limits for instance) to capture spread or trading gains is a simple way to always lower costs, with no repercussions. In reality, trading passively exposes the trader to adverse selection (the possibility that the trades they do complete will underperform while the trades they don't complete will outperform) and often ignores the opportunity cost. Including the opportunity cost, it's not uncommon for total costs to be higher for passive orders than aggressive orders.

     Many trading costs studies have been published using older data that give some perspective from independent sources. In “Scale Effects in Mutual Fund Performance: The Role of Trading Costs,” Roger Edelen, Richard Evans, and Gregory Kadlec estimated equity trading costs and determined that at that time they were comparable in magnitude to the expense ratio (1.44% versus 1.23%, respectively).44 They also found that flow driven trades are significantly more costly than discretionary trades. Average annual trading costs ranged from 0.77% for large cap funds to 2.85% for small cap funds, whereas average expense ratios ranged from 1.12% for large cap funds to 1.34% for small cap funds. They suggested that funds with large relative trade sizes trade well beyond the point of cost recovery. According to their data, commissions were flat at 0.13% from 1995 - 2005, but the spread dropped from 0.27% to 0.06% and price impact dropped from 0.93% to 0.26%.

     In “Portfolio Transactions Costs at U.S. Equity Mutual Funds,” Jason Karceski, Miles Livingston, and Edward O'Neal estimated equity funds incurred an average annual explicit brokerage commission of 0.38% and an average annual implicit trading cost of 0.58% (using 2002 data).45 They found about 46% of all small cap mutual funds had trading costs that were higher than the annual fees investors payed. They suggested that many mutual fund investors were completely unaware of these trading costs and simply assume that the reported expense ratio includes them. Investors can attempt to access the data from the source Statement of Additional Information via the SEC’s Edgar database.

     Attempts to analyze fixed income (bond) transactions costs have historically been far less common, but progress has been made. There clearly are real costs in fixed income trading especially when an investor buys from a broker's inventory (in which case the price may be marked up significantly) rather than on the open market. The methodology for analyzing bond trading costs had historically been hampered in part due to a lack of transparency and market data for many fixed income securities. An early paper by Paul Schultz estimated average round-trip trading costs to be about $0.27 per $100 of par value.46

     A 2007 paper summarized the improvement in transparency of corporate bond trading using NASD's TRACE (Trade Reporting and Compliance Engine) data from Jan 2003-Jan 2005 (over 12 million trades, representing over $9 trillion dollars of volume).47 The system became operational on July 1, 2002. By the end of their sample period, prices from about 99% of all trades representing about 95% of the dollar value traded were disseminated within 15 minutes. They "found that transaction costs were lower for transparent bonds than for similar opaque bonds, and that these costs fall when a bond’s prices are made transparent. We interpret these results as evidence that transparency has improved liquidity in corporate bond markets." They found that corporate bonds are expensive for retail investors to trade. Effective spreads in corporate bonds averaged 1.24% of the price of representative retail-sized trades.

     Kenneth French used information from Financial and Operational Combined Uniform Single (FOCUS), which included broker's commissions and gains/losses from market making to calculate trading costs that are much lower than other estimated trading costs, presumably because he intentionally did not include impact between investors (which are a transfer) and not a cost to society. French estimated a 92% reduction in trading costs, from 1.46% in 1980 to a tiny 0.11% in 2006. As French and others point out, the trading costs do not necessarily reflect a cost to society, in fact much of the trading costs are transfers from one investor to another (but they represent lost alpha in the Implementation Shortfall methodology regardless).

Sidebar: A hypothetical trading cost example

     Let's say Jane and Ken attend a computer show. They are at an exhibit where the presenter shows them a new device that has both of them saying "that's really cool." The presenter tells them the device will go on sale the next day and he expects it to be a big hit. One of them jokes that maybe it’s a good time to buy the stock. They both chuckle and walk away in different directions.

     Jane opens up her laptop and immediately puts in an order through her discount broker to buy 500 shares of the company, which last traded at $10. She crosses the bid-ask spread (paying 10.01) and pays a $5 commission ($5,010) and with a cost of .1% or 10 basis points. Let's imagine Ken is a hedge fund manager. As he walks away he calls his head trader and tells him to buy 1 million shares of the stock, or whatever he can get by the close that day. At first his trader starts getting decent size trades, but then the supply of sellers dries up and the market seems to sense something is going on. By the end of the day they have filled half the order and the stock is up 7% to $10.70 (their average cost for the 500,000 shares comes to 5% or 500 basis points).

     By the open the next day, several favorable online articles have appeared about the device and the stock is up on the open another 3% to $11. Jane is ecstatic, because she's up almost 10% in one day. Ken is both happy and sad. He payed 5% for the shares he got and they are up almost 5% (his shares cost $5,250,000 and are worth $5,500,000 for a gain of just under 5%). But he only got half the order traded, so he has an opportunity cost of -10% on the 500,000 shares he didn't get. His implementation shortfall for the million share order is the trading cost on the shares he traded (50% * -5%) plus the opportunity cost on the shares that did not get traded (50% * -10%) = -7.5%. In other words, in theory his idea to buy the 1 million shares of the stock could have made him 10% or $1,000,000, but in reality his fund only has a $250,000 gain. Of course, if he were to try to sell his 500,000 shares he may find that he not only hasn’t made that much money, he may lose money because the selling of 500,000 shares could drive the stock back below $10 (but given the positive news it’s unlikely).

     In this fictitious example it would be difficult to tell if the stock moved because of Ken’s buying, or because of the news. Supporters of the efficient market hypothesis would suggest that the market likely knew about the new product and the question is not whether it was a successful launch, but whether the launch was received better or worse than the market already expected.

     Money managers are required to seek best execution for their clients, but the term “best execution” has not been defined by the SEC. Some firms might consider best execution beating an average price over a certain period of time, while others might consider implementation shortfall (or price move from start time) relative to industry averages to be a primary metric for determining the best execution. What is important for individual investors is being aware of the costs and how they impact performance.

The Bid Ask Spread and Market Making
Commission costs have dropped significantly in the last century and trades recently tended to cost $5 or less at many of the largest online brokers. Several prominent firms recently began offering no commission trading, but the firms obviously make money other ways. Jason Wenk at Altruist also uses an iceberg in comparing commissions to total investing costs. Miniscule commissions are a great benefit to investors, but they can make it easy to lose sight of the fact that commissions are not the only cost of buying and selling securities. Brokers, specialists, and market makers participate in the markets only when they expect to make profits. Those profits are the price that investors and other traders pay in order to execute their orders when they make trades.

     The most common price for referencing stocks is the last trade price, but the last price is not necessarily the price that a person can subsequently trade now, or in the future. At any given moment during market hours there is a best or highest "bid" price from someone that wants to buy the stock and there is a best or lowest "ask" price from someone that wants to sell the stock. Additionally, that bid and ask will be for a specific number of shares.

     In every transaction one party is a price setter and the other party is a price taker. The price taker agrees to the price set by the price setter. In financial markets, a person who places a market order is effectively a price taker (a market sell order will be filled at the prevailing best bid price and a market buy order will be filled at the best ask price). A person who places a limit order is a price setter, while a person who places a market order crosses the spread and effectively incurs a cost of half the spread. The person who placed the limit order captures that half spread. The risk for the person who places a limit order is that the order never gets filled because the price is never met.

     Let’s look at another example of stock XYZ, which is currently quoted at 100 by 100.25. In other words someone is willing to buy XYZ at 100 and someone is willing to sell XYZ at 100.25. An investor that places a market order to buy 100 shares of XYZ at the market will get executed at 100.25, while another investor that places a market order to sell 100 shares of XYZ will get executed at 100. If the market maker placed both the bid and the ask prices and executed both orders, he will earn the 0.25% as a profit. The market maker profits by doing this over and over again throughout market hours. The market maker loses money when he/she fills an order and reverses the trade at a worse price.

     The following is an example of how a market maker can lose money. An institutional investor places a market order to buy 100,000 shares of XYZ. The specialist agrees to sell the shares at a price of 101. The market maker is now short 100,000 shares (he borrowed the shares) of XYZ and will make a profit if he can buy back the 100,000 shares for less than 101. However after completing the order, the same buyer places an order to buy another 200,000 shares. The market maker now has an outstanding order to buy more shares, yet the market maker’s interest is also to buy the shares back at a lower price to cover his short position. The term getting "bagged" is used by some to describe the market maker’s situation. In other words, a trader or market maker completes a trade only to have the opposing party (or others) push the price further by transacting even more shares in the market.

     When transacting large orders, the market maker usually operates with the hope that the opposing party is finished transacting in that stock or that he has charged enough of a price concession to make up for any subsequent price impact from additional trades. But if the completed order is only part of a larger decision to buy more shares, the market maker can lose money as the additional buying pressure causes the stock to rise further.

     Returning to the original XYZ example, let’s take an example of a person who places a buy order for 100 shares at 100.12. This person is attempting to save half the spread cost by placing a limit order. If the price rises and the order is never filled, the investor will either have to live without the stock or pay a higher price. If the stock subsequently goes to 101, a person who placed a market order and paid 100.25 is clearly better off than the person who originally placed the limit order hoping to save part or all of the spread, but never actually purchased the stock because it moved higher. Of course, we would all make the correct choice if we knew in advance what was going to happen. Therefore, the motivation for the trade should be considered when deciding whether to place a market order or a limit order. If the order is not time sensitive, a limit order may end up costing less, but a market order may be the only way to get an order filled, if the order is time sensitive and the price moves against you.

     Institutional investors (like the firms I consulted to for over a decade) face the challenge of completing massive orders (often millions of shares). An institutional investor that exposes an order for a large number of shares can expect the price to jump immediately, so they may instead attempt to gradually work the order in small pieces over several days or weeks. Day traders and market makers will frequently try to buy or sell in advance of large working institutional orders if they can identify a large order in progress.

     Institutional investors try to reduce their costs by trading with institutional brokers that specialize in handling large block orders and by using trading systems designed to match orders with other institutional traders. These systems attempt to eliminate or reduce the spread and any price impact. The first so-called dark pool was ITG’s POSIT, but now there are many networks and exchanges that large investors can access. While trades completed through these systems tend to have lower up-front costs, traders run the risk of simply not getting their orders executed quickly, or at all. Institutional investors incur opportunity costs as a result of not completing large orders and these costs can be a significant factor in performance.

     The purpose of a market is to provide a location where buyers and sellers can transact. The more buyers and sellers at any given time, the more efficient a market will be in matching buyers and sellers with minimum effort and costs. Electronic communications networks and dark pools work well when many market participants use the system simultaneously.

     The NYSE and AMEX historically were specialist markets. A specialist was assigned to each stock and the specialist maintains a book of current bids and asks. In specialist markets, a market maker is expected to provide liquidity (by using their own capital) for large orders when buy and sell orders do not balance. The market maker takes the risk that prices will move against his position but also has the advantage of seeing the limit orders.

     On NASDAQ there is no specialist, so large orders can result in large price moves. NASDAQ uses a network of dealers connected electronically. Dealers place bid and ask prices on a continuous basis and trades are linked and executed electronically. Day traders historically tended to concentrate on NASDAQ stocks because orders and executions can be placed and confirmed with virtually no time delays. Orders placed on the NYSE historically could take longer.

     On some occasions (like the "flash crash" on May 6, 2010) limit orders can get exhausted and as a result new orders have few or no orders to match with, which can cause larger than normal price moves.

     Generally, the more liquid the stock, the smaller the spread. Penny stocks and options have notoriously large spreads. A recent study found that spread costs on the largest stocks could be virtually zero on the close of trading, but spread costs on the smallest cap stocks near the market open could cost over -7%.48

     If a security has a spread of several percentage points, an investor or trader attempting to make money would have to get several percentage points of price movement just to break even on a trade using market orders. Day traders tend to trade in very liquid stocks that have very small spreads.

     With the rapid growth of ETFs, investors and traders using them should be familiar with the spread costs associated with trading specific ETFs. Mutual funds trade on the close, but ETFs trade continuously and if they don't have enough liquidity, trading them could result in significant costs.

     A difference between a professional market maker and a day trader might be that a day trader will generally open a trade and immediately try to reverse the trade while a market maker will not immediately try to reverse each trade. Over the course of the day the market maker will try to balance his book, but he will generally have more capital available and is more concerned with the average of many trades than concentrating on each individual trade during the day.

     A distinction to be made with professional market makers and day traders is when they cross the line from market making activities to taking positions in order to speculate on the direction of securities. Some day traders are truly speculators trying to outsmart the market by buying in advance of market rises and selling in advance of market declines. This however is a zero sum game where someone wins a dollar for every dollar lost by someone else.49

     We know that market making is a profitable business because public securities firms regularly report profits from their securities trading departments and NYSE specialist firms are very profitable. Whether or not day traders make money is a separate question, which I’ll elaborate on in the next chapter. Of course, we know that day trading brokerage firms and software makers can make money whether or not their customers do and it’s certainly in their interest to encourage more trading.

     As technology and communications have evolved, market making firms are increasingly employing sophisticated computer systems to trade and make markets. Individuals trading in the markets are far more likely now than in the past to be trading against a computer than against another individual.

“…to summarize, you are engaged in a life-and-death struggle with the financial services Industry. Every dollar in fees and expenses you pay them comes directly out of your pocket. (Be aware that you’re often getting charged far more in mutual fund fees than that ‘expense ratio’ listed on the prospectus or annual report, which is often exceeded by the ‘transactional costs,’ that is, adverse price changes that result from moving around millions of shares, much of which accrues indirectly to the fund company.) Act as if every broker, insurance salesman, mutual fund salesperson, and financial advisor you encounter is a hardened criminal, and stick to low-cost index funds, and you’ll do just fine.”
William Bernstein, If you can

Notes - The Footnotes in the Book are sequential and for this chapter start at #113 and end at #162.

5. Brad Barber, Terrance Odean, and Lu Zheng, Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows (later published in The Journal of Business in 2005)
6. Todd Houge and Jay Wellman ,The Use and Abuse of Mutual Fund Expenses, Journal of Business Ethics, Spring of 2006
7. Money managers could escape big 12b-1 fee changes, Pensions and Investments, April 1, 2010
8. Daniel Bergstresser, Peter Tufano, and John Chalmers, Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry (later published in the Review of Financial Studies, December 2009)
9. (see also
11. Report Finds Merrill Lynch Charges Investors Highest Fees, September, 24, 2015
15. Burton Malkiel, Automated Investment Services, Journal of Investment Management, Fourth Quarter 2016 John Bogle, "The Train Wreck Awaiting American Retirement," in interview, Frontline: The Retirement Gamble, New York: PBS television, 2013
17. Beneath the 2017 Rally: Less Trading, Wall Street Journal, October 19, 2017
18. Burton Malkiel, Asset Management Fees and the Growth of Finance, Journal of Economic Perspectives, Spring 2013
20. John Bogle, The Arithmetic of “All-In” Investment Expenses Jan/Feb 2014
22. for instance, see
24. Morningstar posts its annual fee study at
25. Russel Kinnel, How Expense Ratios and Star Ratings Predict Success from Morningstar, August 9, 2010
28. Chalmers and Reuter (2014)
29. (Foerster et al. 2014, Hackethal et al. 2012a).
30. How High Is Too High for 401(k) Fees? Consumer Reports, December 31, 2018
31. December 2014 Ayres and Curtis estimated the average 401(k) plan costs 42 basis points and all in fees are 113 basis points. "Beyond Diversification: The Pervasive Problem of Excess Fees and Dominated Funds in 401(k) Plans," Yale Law Journal (2013)
33. (June 5, 2017)
36. (July 16, 2019)
37. (July 09, 2019)
38. Meketa Investment Group provides data on the percentage of investor capital paid in fees (and provides other interesting data on administration costs, legal & compliance, audit & tax professional, research, and other). See
41. For more on the history, see The Incredible Story of Transactions Cost Management: A Personal Recollection by Wayne Wagner in the Summer 2008 issue of The Journal of Trading.
43. Andrea Frazzini, Ronen Israel,and Tobias Moskowitz, "Trading Costs" April 2018,
46. Paul Schultz, Corporate Bond Trading Costs: A Peek Behind the Curtain (JOF) April 2001
47. Amy Edwards, Larry Harris, and Micheal Piwowar, “Corporate Bond Market Transaction Costs and Transparency,” Journal of Finance, June 2007
48. Brian Livingston, "You’re paying too much for small stocks," Jan 15, 2019
49. See Larry Harris, The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity

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