Turnover represents the average length of time that a security remains in a portfolio. Dividing 1,200 by the turnover rate reveals the average number of months a manager holds his positions. For instance, a turnover rate of 100% means the manager holds a security in his portfolio for an average of 12 months.
The ITG data yields at least two important observations. The first is that transaction costs have trended downward over the past five years. In 2003, U.S. large-cap two-way transaction costs totaled 146 basis points per 100% turnover. In 2006, the corresponding annual cost was 92 basis points, a decline of 54.
The second observation is that brokerage commissions historically have constituted a minor share of total transaction costs. Of the 54-basis-point decline between 2003 and 2006, a savings of 13.5 basis points was due to lower brokerage commissions.
Similar trends are evident for small-cap equity transaction costs. In 2003, annual two-way transaction costs for 100% turnover averaged 226.5 basis points; in 2006, 148.5 basis points. Of that 78 basis point decline, 22 points were due to lower transaction costs.
Implications For Fiduciaries
Despite the fact that transaction costs and expense ratios are analogous and similarly expensive, fiduciaries pay close attention to the latter and typically neglect the former. For instance, HR Investment Consultants' industry-standard 401k Averages Book helps fiduciaries benchmark plan costs, but it does not address transaction costs. Expense ratios constitute about 90% of the book's cost benchmarks; if transaction costs were included, it would approximately double the benchmarks.
Therefore, plan fiduciaries should attend to transaction costs. Prudent fiduciaries rely on a meticulous decision-making process, and that process should account for transaction costs. Investment dollars ideally flow only to those investment companies that provide fiduciaries with the necessary data.
If total transaction costs cannot be obtained, fiduciaries should strongly consider index funds as an alternative to actively managed funds. Index funds incur about 80% less in transaction costs than actively managed funds without sacrificing performance. An industry mantra holds that long-term returns for actively managed funds trail their respective indexes.
H.R. 3185
Congressman Miller's H.R. 3185, "The 401(K) Fair Disclosure For Retirement Security Act Of 2007," requires disclosure of "estimated trading expenses" to plan sponsors as well as disclosure of "[estimated] trading costs" in the participants' annual statement. Estimates lack specificity, however, and could prove useless. Investment companies have a financial incentive to provide generic data, so that comparisons between funds lack credibility.
The bill anticipates disclosure of explicit costs, such as brokerage commissions, but uncertainty exists regarding implicit transaction costs. The language of the bill does not refer to implicit costs by name (for example, timing delay costs, impact costs, bid/ask spreads, etc.), and the congressman presumably would have named them if that were his intention. That omission can be rectified in future revisions, though these would give rise to the problem of standards and conformity. At the moment, firms tally transaction costs using a variety of algorithms and methods, and there is no consensus about any one way of measuring them.
In 2003, the SEC noted, "Because the implicit costs, which are difficult to identify and quantify, can greatly exceed the explicit costs, there is no generally agreed-upon method to calculate securities transaction costs." If Rep. Miller does not impose a single standard for computing transaction costs, then the reported data will be constantly under attack from rival firms using alternative methods. If the congressman does impose a single standard of computation, then he elevates some vendors and injures others.
Proposed SEC And DOL
Regulations Fail The Test