Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

I. Transaction Cost Analysis as Part of the Investment Process

measure the transaction costs of past trades, estimate the transaction costs of future trades and allow comparisons across trading strategies for a specific trade list, as well as measure the trading performance of the intermediaries. All the information collected in this phase must then be used in the other phases to avoid misallocation of funds, inefficient portfolio mixes and ineffective intermediaries. TCA thus contributes to enhanced total performance over the entire investment decision cycle. To allow the reader to view this report in light of hard figures, Karceski, Livingston and O'Neal (2004) established that actively managed equity portfolios bear a total of 0.98% transaction costs per year. To a significant degree, those costs are implicit and are therefore not reported in total expense ratios.

trades and hence occurs ex post . By contrast, transaction cost estimation attempts to forecast the cost of proposed trades. Basically, transaction cost measures and estimates differ in two main ways. First, transaction cost measures result in single point values expressed in either monetary units or basis points per share, while transaction cost estimates are expressed as a probabilistic distribution defining both an expected cost and a risk parameter. Next, estimation is essentially based on cost components and drivers, while identifying and measuring each cost component is not so obvious ex post . When dealing with TCA, it is also of great importance to understand how trading performance evaluation differs from transaction cost measurement, even if both are done ex post . Performance evaluation attempts to assess how well intermediaries perform when executing trades. The ultimate aim is to determine the most effective intermediaries by market, instrument and trading strategy. With this information at hand, investment managers can considerably reduce the time required to select the best intermediary for the execution of a specific trade. While transaction cost measurement focuses on determining how large transaction costs are and where they arise, the analysis of trading performance involves determining whether the costs are justified or result from poor implementation decisions and could have been avoided. By nature, all the tasks assigned to TCAmust be performed within the execution services phase of the investment decision process. It is there that quantitative procedures and approaches can be developed to

11 An EDHEC Risk and Asset Management Research Centre Publication