Manager selection and oversight activity for fiduciary managers is continuing to accelerate. With that acceleration, we have noticed that transaction cost analysis is starting to become a far more regular feature in our interactions with clients and their advisors.
The very nature of a fiduciary management relationship, with the increased scope for outsourcing of investment decision making and implementation, requires that Trustees have confidence in the capabilities and values of their fiduciary manager. The area of transaction cost management and reporting is no different. Given the impact of transaction costs on returns, Trustees should gain the necessary comfort that their fiduciary manager has the appropriate investment implementation resources, governance structures and reporting capability to manage transaction costs and deliver meaningful transparency.
It is important to note that transactions are necessary to manage portfolios and to generate returns for clients. One has to buy or sell assets at some point to create the return generating portfolio. Returns generated are the outcome of those transactions. As reporting of transaction cost figures becomes more widespread, using transaction costs for investment decision making is becoming more common.
However, this does not mean that high transaction costs are necessarily bad and they certainly do not mean a ‘more expensive fund', they are a function of the style of portfolio management. Lowering transaction costs will not necessarily result in higher returns. What we can say with certainty is that a different set of transactions will result in a different portfolio and hence level of return.
The concept of best execution is critical to managing transaction costs and avoiding erosion of returns. Transaction costs exist because buying and selling securities is not frictionless. Since this friction translates into lost value, at Schroders we transact on behalf of clients to minimise the value that is lost by optimising the way we trade. This is what "best execution" is. In simple terms, it means executing a trade in the best possible way.
Having the right infrastructure and the right governance structure are pre-requisites to successfully managing transaction costs and achieving best execution.
The right infrastructure
In trying to achieve best execution, your fiduciary manager must take into account many different (sometimes conflicting) factors at the same time, such as:
- the price of the security that is being traded
- the liquidity of the security
- the size of the trade compared to the total volume that is traded
- the orders that are being filled by other market participants
- the urgency in completing the trade and
- all the possibilities to fill that order (through different brokers and using different trading venues, etc.)
Figure 1: Best execution : how we define and monitor best execution
The right governance structure
Even though governance is not explicitly mentioned in the best execution regulations, good governance and oversight by your fiduciary manager within best execution should prevent inefficient trading that results in unnecessarily high transaction costs and lower value for your scheme.
Having separate portfolio management and trading functions is essential. The portfolio manager makes the decision to trade but it is the trader who is responsible for executing each trade subject to any restrictions or conditions imposed by the client.
Our integrated fiduciary management solution means our clients benefit from a joined up platform where we can manage costs effectively. Our clients have growth portfolios with a separate portfolio management and implementation function. We are extremely cost-aware. Before implementing a new investment idea in our clients' fiduciary portfolios, the costs of adding the new position and selling existing holdings are fully considered in the context of their impact on return.
Transaction cost figures certainly have a purpose. Transaction costs, particularly alongside information on best execution, can indicate how efficiently your fiduciary manager has delivered against the investment objective.
The intention behind requiring their disclosure is that, along with other fund attributes, such as if the fund is actively managed, or what is the net return, they can give a fuller picture of what the solution is trying to achieve and how well it has achieved it. Having that integrated fiduciary management model outlined above, increases transparency and the ability to understand how costs associated with trading impact your portfolio. We remove unnecessary layers, making everything more transparent and ensuring connectivity of solution components across growth and matching portfolios.
At Schroders, our focus on having the right infrastructure, the right resource and the right governance structures is essential to successfully managing transaction costs. Just as important is the right culture; a culture of disclosure and of being close to your clients, of delivering the right information and the right support to facilitate meaningful interpretation of that information. All of these features become magnified in a fiduciary relationship, where Trustees are outsourcing both day-to-day investment decision making and implementation. Our approach, removing layers between our clients and their investments, allows us to provide unique levels of oversight which delivers the effective investment governance that Trustees entrust us with.
We have produced a detailed paper on transaction costs and the considerations for Trustees within fiduciary management which can be accessed here