Understanding costs

Equity market investors face so many unforeseeable risks that it seems almost petty to mention costs.

However, in equity markets investment costs can run between 2% and 5%/year - high enough to alter the balance of potential reward versus risk.

Investment costs resemble the time lag on telephone calls. Normally, the tiny gap between when you speak and when the person on the other end of the line hears you doesn't affect the conversation.

But when the phone infrastructure is less well developed the delay can become noticeable and impede effective communication.

Similarly, investment expenses that investors are used to ignoring in the developed equity markets suddenly become large enough to matter within the emerging markets. Consequently, adaptive mechanisms are needed to cope with them. Investors are required to adapt their trading, operations and investment approach to succeed in equity markets.

This paper explores the strategies that investors can use to help control the high costs of equity market investing.

Equity market investing is costly

We estimate that the total investment costs for an equity account in a typical emerging market are between 2% and 5%/year - certainly an amount large enough to warrant attention. The costs fall into three broad categories (Graph 1).

First, there are investment-management fees. These are based on the total value of assets. While in other emerging markets these fees range between 0,8% and 1,5%, fees in SA are remarkably low, typically running between 0,25% and 0,55%. They're also very visible, simply because they're normally specified in a contract with the manager.

Second, there are the operating costs, which include fees paid to custodian banks, legal fees, accounting fees, pricing fees and other costs related to the admin and the operation of an account. These costs are generally fixed, though there are some asset-based and transaction-based components as well. For large accounts, we estimate these costs run at about 0,2% and 0,3% of assets.

Finally, there are transaction-related costs - expenses incurred every time there's a trade in the portfolio. These include broker commissions, taxes and the bid/ask spreads paid to the market makers. Transaction costs are embedded within the returns for every holding and, consequently, they're nearly invisible.

Yet they represent the single largest element of emerging-market equity investment costs: we estimate transaction costs can be as high as 4%/year. That combination of high magnitude and low visibility makes managing transaction costs especially vital.

Transaction costs

Market impact

We analysed the composition of transactions costs by looking at our own trading experience locally over the past five years. The costs to buy and sell a stock averaged approximately 1,5% to 2% of stock price. The largest component by far - the bid/ask spread - averaged 1% of the stock price. Mid caps bid/ask average 2,5%. The other components were broker commissions (averaging 0,5%) and the taxes to Government (averaging 0,1%). Emerging-markets costs are significantly higher at 3,6%, with the bid/ask spread being the largest component, averaging 2,5%.

Why are the bid/ask spreads in local equity so high? Simply put, market makers have to cover their risks, as they fill the gap between buyers and sellers. The more volatile a stock, the greater the risk of being caught holding it during a downturn.

As a result, the average bid/ask spread tends to track market volatility fairly closely (Graph 2). When the volatility of the FTSE/JSE all share index rose dramatically during 1998 and into the 1999 Asian crisis, liquidity dried up and spreads rose.

That was very pronounced in the mid cap sector of the market, where the spread average was as high as 3%. As volatility dropped after the crisis, spreads narrowed again. Is it wise to have a longer holding period in such volatile markets?

Because the bid/ask spread in equity markets is so closely related to volatility (mid and small caps are extremely illiquid), getting into or out of a market in times of high volatility can be extremely costly.

Attempting to exit a market that's slumping and then re-entering when it begins to turn up may actually cost more than staying invested through the market cycle.

Stockbroker commissions

Stockbroker commissions vary sharply, ranging from 0,10% to 0,30% depending on the transaction value. However, commissions in SA are much lower than in other emerging markets. For example, Malaysia and Indonesia are at 1,7%. In SA the market has been deregulated and competition is high relative to other emerging markets, but lower than developed markets.

Reducing turnover

The simplest and most effective strategy for cutting transaction costs is reducing turnover. The average transaction costs for a R100m equity portfolio with 100% turnover, not atypical for active equity market investment managers, would be about R2m/year. By contrast, a portfolio with 50% turnover would incur just R1m/year in transaction costs. In other words, the active trading strategy has to generate at least R1m in additional return just to break even. Less trading may therefore pay.

Prudent investors need to understand these tradeoffs when assessing a given manager's strategy.

Estimating after-cost returns

In summary, cost-effective trading is clearly a crucial element in equity investing.

Each trade needs to provide enough potential return to justify the round trip transaction costs.

Perhaps the most comprehensive approach to controlling costs is to incorporate the estimated transaction costs for each security into calculations of that security's attractiveness.

For example, even if a small cap stock had higher potential return than a large cap stock on a pre-cost basis, its expected return might well be lower, given that the small cap average cost is higher than large cap. In this instance a portfolio that failed to take the transaction costs into account is likely to underperform over time.

The effect of scale on operating costs

Though operating costs - such as custody, legal, accounting - may be the smallest segment of total cost, managing them is still important. The fixed nature of operating costs has significant implications for the efficiencies of scale in equity market portfolios versus other asset classes. For small equity market accounts the operating costs are much higher than the 0,2% to 0,3%/year level cited earlier.

Generally, the best way to enjoy economies of scale is to participate in pooled vehicles with other equity investors. Different types of pooled vehicles are available to meet the needs of different types of investors, including unit trusts. The growth of the multimanagers in recent years is evidence that pension fund trustees are cognisant of the cost implication of maintaining segregated accounts.

Joining smaller accounts also creates the opportunity to reduce transaction costs by netting cash flows among the pool's participants. Incoming cash from one participant can be used to cover withdrawals from another participant, reducing the volume of stocks that need to be bought or sold. Still, investors should ensure that when entering or exiting a fund they pay their own way, so that longterm participants don't wind up subsidising the costs of short-term traders. Levying transaction fees paid into the fund's net asset value, or using holding accounts to segregate assets moving into or out of the fund, are two ways to address that.

Investment management fees

The final major element of expense is the investment management fee. Equities are generally the most expensive asset class from this perspective. Trustees of large funds often try to mitigate that cost by introducing passive core strategies. However, in many markets a purely passive strategy isn't always the best solution. SA would certainly be one of those markets.

Markets that experience scarcer research coverage, inherent inefficiencies, high volatility and periods of high concentration of specific shares or sectors are markets where active strategies pay off the most, particularly when the same characteristics of unstable market sector weights force index trackers to buy high and sell low.

For that reason, while a passive core can lower costs the addition of an active strategy can generally reduce volatility and create a critical robustness to a South African equity strategy.

To illustrate, we compare the weights of gold and banks on the FTSE/JSE all share index over the past several years (Graph 3). In the second quarter of 2000, banks accounted for 13,8% of the index, while gold was low at 3,5% of the index.

At end-2002, gold peaked at 10,6% as it outperformed the market and banks reached a trough at 8,9% in September 2003. Active managers can take advantage of these value distortions by trading them. Additionally, because of research inefficiencies in SA added returns from stock selection could be significant. While individual stock returns always vary, the range on the JSE is extraordinary. For example, in 2004 the FTSE/JSE all share was up 25,4%. The table shows that there was a range of returns across the market and within sectors.

We only considered the investable universe of large and mid caps, as small caps can be very illiquid. However, the best performing stock in 2004 was small cap platinum producer Barplats Investment, up 420% over the year. You would have outperformed the market during 2004 if you were overweight in general retail stocks (78%) and had no exposure to gold (-38%).

Clearly, there's significant additional return available from stock selection, reflecting the fact that equity markets are inefficient.

Conclusion

In sum, many think the cost of equity market investing is high but manageable.

It's critical to know what factors drive these expenses and to adjust your investment approach accordingly.

The potential for active management to exploit market inefficiencies may make it more cost-effective than passive management: managers have scope to deliver additional returns well above their fees.

Finally, because transaction costs are very high it's critical to minimise turnover and only trade when the potential return outweighs the costs.

James Hatuikulipi

JAMES HATUIKULIPI holds a BCom (Accounting) from the University of Namibia and a BCom (Hons) in portfolio management and financial analysis from Cape Town University.

At Alliance Capital Hatuikulipi is responsible for the Namibian portfolios and part of the team that manages the South African balanced accounts.

He sits on the asset allocation committee and is a member of the SA Growth Equity portfolio management team.