an empirical study of mutual fund trading costs

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AN EMPIRICAL STUDY OF MUTUAL FUND TRADINGCOSTS

Paper presented by:- Mr. Solanki Ashvin H.Lecturer, R.K.College of Bussiness

Mgt. Rajkot Bhavnagar Highway,Kasturbadham Rajkot - 360020

AbstractWe directly estimate annual trading costs for a sample ofequity mutual funds and find that these costs are large andexhibit substantial cross sectional variation. Trading costsaverage 0.78% of fund assets per year and have an inter-quartile range of 0.59%. Trading costs, like expense ratios,

are negatively related to fund returns and we find noevidence that on average trading costs are recovered inhigher gross fund returns. We find that our direct estimatesof trading costs have more explanatory power for fundreturns than turnover. Finally, trading costs are associatedwith investment objectives. However, variation in tradingcosts within investment objectives is greater than thevariation across objectives.

INTRODUCTION

Of late, mutual funds have become a hot favourite ofmillions of people allover the world. The driving force ofmutual funds is the safety of the principal guaranteed, plusthe added advantages of capital appreciation together withthe income earned in the form of interest or dividend. Peopleprefer mutual funds to bank deposits, life insurance andeven bonds because with a little money, they can get intothe investment game.

WHAT IS A MUTUAL FUND?

To sate in simple words, a mutual fund collects thesavings from small investors, invest them ingovernment and other corporate securities and earn


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income through interest and dividends, besidescapital gains.It works on the principle of small drops of water make a bigocean.

For instance, if one has Rs.1000 to invest, it may not fetchvery much on its own. But, when it is pooled with Rs.1000each from a lot of other people, then, one could create a bigfund large enough to invest in a wide varieties of shares anddebentures.

SHARE VS FUND

Investment on equity shares can be used as a tool byspeculators and under this make a abnormal profits. Thesepeople play an investment game in the stock market on thebasis of daily movement of prices.

But, mutual funds cannot be invested for such purposes andthe mutual fund is not at all concerned with the daily priceand flow of the market.

TYPES OF FUNDS

In the investment market, one can find a variety of investorswith different needs, objectives and risk taking capacities.For instances, a young businessman would like to get morecapital appreciation for his funds and he would be preparedto take greater risks than a person who is just on the vergeof his retiring age.

So, it is very difficult to offer one fund to satisfy all therequirements of investors. Just as one shoe is not suitable forall legs, one fund is not suitable to meet the vastrequirements of all investors. Therefore, many types of fundsare available to the investor.


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(A) On the basis of execution and operation

(1) Close-ended funds:-

Under this scheme, the corpus of the fund and its durationare prefixed. In other words, the corpus of the fund and thenumber of units are determined in advance. Once thesubscription reaches the pre-determined level, the entry ofinvestors is closed. After the expiry of the fixed period, theentire corpus is disinvested and the proceeds are distributedto the various unit holders in proportion to their holding.

Thus, the fund ceases to be a fund, after the finaldistribution.

Features:-- The period and/or the target amount of the fund is

definite and fixed beforehand.- Once the period is over and/or the target is reached,

the door is closed for the investors. They cannotpurchase any more units.

- These units are publicly traded through stock exchangeand generally, there is no repurchase facility by thefund.

-The main objective of this fund is capital appreciation.

- The whole fund is available for the entire duration ofthe scheme and there will not be any redemptiondemands before its maturity.

- At the time of redemption, the entire investmentpertaining to a close-end scheme is liquidated and theproceeds are distributed among the unit holders.

(2) Open-ended funds:-It is just the opposite of close-ended funds. Under thisscheme, the size of the fund and/or the period of the fund isnot pre-determined. The investors are free to buy and sellany number of units at any time. For instance, the unitscheme (1964) of the Unit Trust of India is an open-endedone, both in terms of period and target amount. Anybodycan buy this unit at any time and sell it also at any time.


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Features:-- There is free entry and exit of investors in an open-

ended fund. There is no time limit. The investor can join

in and come out from the fund as and when he desires.- These units are not publicly traded but, the fund is

ready to repurchase them and resell them at any time.- The main objective of this fund is income generation.- The investor is offered instant liquidity in the sense that

the units can be sold on any working day to the fund.

STRATEGY OF TRADING COST

Mutual fund returns are negatively related to fund expense

ratios as documented by Jensen (1968), Elton, et al, (1993),Malkiel (1995), and Carhart (1997) among others. While lessvisible than expense ratios, trading costs are anotherpotentially important cost to mutual funds. There are amplereferences to trading costs and their likely effect on fundreturns in the literature, dating back at least to Jensen(1968). However, a direct analysis of fund trading costs andtheir relation to fund returns has not been conducted.1Rather, most research has used fund turnover as a proxy for

fund trading costs. We estimate mutual funds equity tradingcosts and the association between those costs and fundreturns. The trading costs that we focus on are spread costsand brokerage commissions.

Spread costs are tallied using a fund-by-fund, quarter-by-quarter examination of stocks traded, accompanied by atransaction-based estimate of the cost of each trade.Brokerage commissions are disclosed in the Securities andExchange Commissions (SEC) N-SAR filing. We combine ouranalysis of fund trading costs with an analysis of fundexpense ratios, which do not include trading costs, toprovide a comprehensive evaluation of fund costs and theirassociation with fund returns.


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Mutual fund costs are critical to analysis of the value ofactive portfolio management. Grossman and Stiglitz (1980)suggest that informed investors trade only to the extent thatthe expected value of their private information is greater

than the costs incurred to gather the information andimplement the trades. Fund expense ratios can beinterpreted as information gathering costs while fund tradingcosts can be interpreted as the cost of implementing aninvestment strategy. Our results confirm the negativerelation found between expense ratios and fund returns andextend the conclusions drawn in indirect analyses of therelation between fund trading costs and fund returns (seee.g. Grinblatt and Titman (1989), Elton et. al. (1993), Carhart(1997) and Edelen (1999)).

ANALYSIS OF MUTUAL FUND TRADING

Our analysis directly quantifies trading costs. We find that,trading costs incurred by mutual funds are large. As afraction of assets under management, spread costsaverage .47% and brokerage commissions average .30%annually. More importantly, there is substantial variation inthese costs across funds. For example, the difference in

trading costs between funds in the 25th and 75th percentileis 59 basis points. This is greater than the 48 basis pointdifference in expense ratios across the same range.

We decompose trading costs into three components:turnover, average spread of fund holdings, and fundmanagers sensitivity to trading costs. Turnover, measurestrading frequency and is a common proxy for trading costs.

Turnover captures roughly 55% of the variation in tradingcosts. The average spread of fund holdings is a measure of afunds average cost per trade and captures 30% of thevariation in trading costs. Finally, fund managers sensitivityto trading costs measures the degree to which the fundmanager executes trades that are more or less expensivethan the average stock in the portfolio. Trading sensitivitycaptures 5% of the variation in trading costs.


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Our analysis sheds light on the value of active fundmanagement. We examine the relation among expenseratios, trading costs and fund returns. We find that fund

returns (measured as raw returns, CAPM-adjusted returns, orCarhart four factor-adjusted returns) are significantlynegatively related to both expense ratios and trading costs.Consistent with indirect analyses of fund returns and tradingcosts (Elton et al (1993) Carhart (1997)) we find a negativerelation between turnover and fund returns. However, therelation between turnover and fund returns is weaker thanthat between our direct estimates of trading costs and fundreturns. In fact, regressions using our direct estimates oftrading costs imply that trading costs have more power than

expense ratios in explaining fund returns. We find noevidence that trading costs are recovered in higher grossfund returns.

INVESTMENT OBJECTIVES AND FUND COSTS

Fund investment objective classifications are an importantdescriptor of mutual funds.

However, they are inherently subjective. Brown andGoetzman (1997) attack the subjective nature of theclassification system by examining the returns of mutualfunds and classifying them by their return characteristics,arguing that these are much more objective measures bywhich funds can be categorized. Given the strongexplanatory power for performance, it strikes us that theexpense ratios and trading costs that funds impose oninvestors provide useful measures by which funds can becharacterized. With this in mind, we provide evidence on thequestion: to what extent is cross sectional variation in totalfund costs, expense ratios and trading costs, explained byexisting investment-objective classifications?

CONCLUSIONS


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We estimate the annual costs of fund managers trades andfind these costs to have a substantial negative associationwith return performance. There are many interestingcontexts in which to interpret the evidence in our paper. One

interpretation of our evidence is that mutual fund managersdo not follow this rule. Alternatively, it could be that much ofthe trading costs we observe are related to the provision ofliquidity as discussed in Edelen (1999). To the extent thatthis trading is unavoidable, the negative associationbetween fund returns and trading costs suggests that it paysto have fund managers who mitigate the cost of such trades.Finally, a plausible, although unlikely interpretation for ourresults is that poor returns cause higher trading costsbecause investors leave funds with poor returns which

generates additional trading costs.

A practical issue that arises from our analysis is that it iscostly to obtain direct estimates of funds trading costs.Given their importance in explaining fund returns, a low costproxy for trading costs may be valuable. Our evidencesuggests that a truly discriminating proxy needs to gobeyond turnover. Unfortunately, the other two componentsof trading costs, the weighted-average spread and cost

sensitivity of trading, are not readily observable. Thus, thesearch for a low-cost proxy for these components wouldhave significant practical value.

Finally, given the widespread use of fund investmentobjectives to classify fund types, we analyze the relationbetween investment objective and trading costs. We findthat on average investment objectives are related to fundcosts in the manner one would expect, that is aggressivegrowth funds have higher average costs than growth andincome funds. However, we also find that variation withininvestment objectives is much larger than variation acrossinvestment objectives. Thus, the impact of trading costsgoes beyond the standard classification of funds investmentobjectives.


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ReferencesBogle, John C., Bogle on Mutual Funds: New Perspectives forthe Intelligent Investor, Irwin Professional Publishing, 1994,Burr Ridge, IL.

Brown, S.J., W. N. Goetzmann, 1997. Mutual Fund Styles.Journal of Financial Economics, 43, 373-399.

Carhart, M, 1997, On persistence in mutual fundperformance, The Journal of Finance, 52, 1, 57-82.

Collins, S. and P. Mack, 1997, The optimal amount of assetsunder management in the mutual fund industry, FinancialAnalysts Journal, September/October, 67-73.

Daniel, K., M. Grinblatt, S. Titman, and R. Wermers, 1997,Measuring mutual fund performance with characteristic-based benchmarks, The Journal of Finance, 52, 1035-1058.

Grinblatt, M. and S. Titman, 1989, Mutual fund performance:An analysis of quarterly holdings, Journal of Business 62,393-416.

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an empirical study of mutual fund trading costs

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