An in-depth study by CEM Benchmarking shows transaction costs for large pension schemes are significant and largely depend on investment strategy. Stephanie Baxter analyses the findings
Pension schemes are increasingly concerned about the level of transaction costs incurred through the trading of securities.
Getting a handle on these costs has been difficult due to a lack of reporting and consistency in disclosure. Driven by regulatory pressures and lobbyists, the UK is moving closer to transparency on transaction costs with defined contribution schemes now having to disclose them in their annual chair's statements. Meanwhile, the Institutional Disclosure Working Group has been working on a standardised disclosure framework for costs and charges.
Costs are material
New research by CEM Benchmarking has found that transaction costs are material and account for around a quarter of investment costs on average.
The provider analysed transaction costs incurred by its ‘global leaders' peer group, which contains 19 large institutional investors with combined assets of more than £2trn, mostly comprising defined benefit schemes (two from the UK) and a few sovereign wealth funds.
Costs captured in the analysis come from the following: broker commissions, taxes, broker research, fixed income and over-the-counter derivative spreads, entry/exit fees, transaction costs for private investments, and costs within hedge funds.
The analysis does not include the cost of acquiring a security between the date of a buy or sell decision and the point of execution, market impact, which is the cost of a security caused by the trade itself.
A fund with the average asset mix in the 19-strong global leaders group is estimated to pay around 86.3 basis points (bps) in total investment costs each year, of which around 20.2bps was incurred by transaction costs. Some 20.4bps were in performance fees, base manager fees and internal management came in at 41.8bps, while governance, custody and operations was 2.6bps.
However, CEM notes that the costs of these large investors are generally higher than its other clients, despite managing more of their assets internally and more efficiently. This is down to larger schemes having a high allocation to private assets that are more expensive than public assets.
When breaking down transaction costs into asset classes, private equity incurred the highest with a median of 48bps, followed by hedge funds with 31.9bps, and fixed income at 21.9bps. Infrastructure cost an average 11.6bps, real estate 6.9bps and public stock just 6bps.
CEM points out that while explicit costs are known or can be easily calculated, the assumptions behind implicit costs can vary a lot because they are harder to identify. The variation around implicit costs, which include bid/ask spreads and mark-ups on OTC instruments, can influence total transaction costs at a fund level by around five to eight bps.
The impact was most apparent when comparing transaction costs within fixed income, where there were big geographical differences.
CEM Benchmarking UK principal John Simmonds says: "Some high trading strategies create a lot of turnover, which may be fine if it's the particular remit that's been given to the manager. But the spreads remain estimates because of the market-making in relation to those fixed income investments."
For example, transaction costs reported by Dutch pension schemes in the analysis showed an average spread of 29bps, compared to just 3bps outside the Netherlands.
According to CEM, some of the variation could be down to the different mixes of trades in sovereign versus credit versus emerging market bonds, and that a lot could be attributed to assumed spreads between different AA government bonds. For example, US Treasuries are estimated to have narrower spreads than European bonds.
"There is more work to be done on why those estimates differ so greatly between the different funds we've spoken to," says Simmonds.
CEM's analysis also looked at trading volumes and transaction costs to compare portfolio turnover. Those costs will be higher if more trading occurs in a portfolio, and CEM found large differences in volumes traded between funds and asset classes. A fund with a 25% turnover rate holds its assets for four years on average; CEM found some funds turn over most or all of their public holdings every year.
While high turnover is something to be aware of, it may not necessarily be a problem; it may reflect a manager's intended strategy or specific remit given by the client. It is important the manager is working within the parameters that are understood and accepted by the pension scheme, according to CEM.
Implications for others
And how do large investors such as those in the global leaders group fare compared to their smaller peers?
"It is too early to say whether large funds pay more total investment costs than small funds, but in broad terms, large funds tend to outperform small funds - not because their costs are low but because they are more efficient in the way they implement their strategies," says Simmonds.
"Looking at enough data over a long enough period, and adjusting for asset mix, there is very little difference in performance between large and small schemes. But what really drives the differential is cost beyond manager fees. We want schemes to negotiate on their fees with managers - but the reason why large schemes tend to have lower cost on an asset-adjusted basis is because they implement their strategies more efficiently - which means more internal management and lower use of high-cost strategies such as fund of fund structures."
This kind of research can be useful to give UK pension schemes a rough idea of what they should be paying in transaction costs for particular assets.
Simmonds suspects that once they start to get good quality comparative analysis, most UK schemes will find that traded volumes and transaction costs will be in an acceptable range, and that any issues will be at the margin.
"Costs for the overwhelming majority will be in the right range, doing the right things, and which will only come into scrutiny if the manager isn't performing to the satisfactory level," he says. "Also, if the manager is behaving outside the parameters expected of them - trading higher volumes, churning portfolios, coupled with poor performance - then you'll be likely to see some dynamic around the edges.
"We will see pension funds become better informed in their buying decision and manager selection process. They will start to pay more attention to those kinds of issues, be more dogmatic as to what they expect from managers, and have more good quality data to point to in the selection process. But any change will be at the margin."
Over the last two years, we have been engaging with companies about the presence of child labour in the cobalt supply chain.
Registration for the UK Pensions Awards 2020 is now open…
The £45bn Border to Coast Pensions Partnership has launched its largest fund to date, with £5bn of Local Government Pension Scheme (LGPS) assets being allocated to global equity alpha.
This week’s top stories included Aon telling the industry there was no excuse for stalling implementation of GMP equalisation, despite further guidance being needed on tax.
Legal & General (L&G) has launched an online annuity searching tool, allowing consumers to compare rates across six leading providers.